Suggested Answers

Suggested Answers to
Text Questions and Problems
and
Answers to CourseTutor
Homework Questions
Suggested Answers to Text Questions and Problems for Chapter 1
1. Some reasons for the increase in economics majors might be: (1) The starting
pay for economic majors upon graduation approaches $50,000 a year; (2) glob-
alization trends are producing a greater interest in knowing how economies
interact; and (3) economic analysis is now being applied to a broader range of
topics including issues such as crime, AIDS, college and professional sports,
and terrorism.
2. Many reasons could be advanced to explain why we think things were better in
an earlier time including (a) media attention seems to focus on problems, (b)
we romanticize earlier times, (c) we get used to what we have and wish we had
more, and so on. Easterbrook provided a long list of other reasons as well.
3. Computers and other technologies require extensive training and experience,
and firms must establish the organizational structure to make the investment
truly effective. For example, it took Wal-Mart a number of years to develop, col-
lect, process, and analyze the immense data it collects from its stores “to deter-
mine specific goods to stock at specific stores at specific times of year as well
as their prices.” See “Computer Use and Productivity Growth,” National
Economic Trends, The Federal Reserve Bank of St. Louis, December 2003.
4. It is probably bound to help somewhat. If only some have horns removed, how-
ever, poachers might still kill the rhino to keep from having to track this animal
in the future. After all, poachers are concerned with efficiency as well. Thus, the
more animals with horns removed, the better the result. Also, dehorning may
make the animals more susceptible to predators. But incentives do matter, and
removing the horn on balance may help the effort to save the black rhino. See
Charles Wheelan, Naked Economics: Undressing the Dismal Science (New
York: WW Norton), 2002, Chapter 2.
5. High-tech firms are hiring expensive, sophisticated people who are in high
demand. This leads to better treatment of employees. If the firm does not offer
these amenities to its employees, they soon become employees of other high-
tech companies. Individuals with low skill levels do not command high salaries
or benefits. They are not in as high demand as highly skilled people. It is effi-
cient, but many would argue that it is not fair. Markets, as you will see, are effi-
cient allocative mechanisms, but fairness is difficult to determine.
6. Yes, clearly going to college instead of going immediately to work represents a
choice to get additional skills now and enter the labor force later. Even if you
are working and going to school, you are choosing between investing in your
education versus another leisure activity. You will see the benefits in the future,
when your skills command greater resources.
7. The government can subsidize hybrid purchases directly, by offering people,
say, $2,000 to purchase cars that get greater than 40 miles per gallon, or offer-
ing tax credits. The government could add significant taxes on gasoline,
increasing the price, making hybrid cars more attractive to consumers.
8. Your study time on Wednesday.
9. All of these groups benefit except the newly married couple trying to purchase
their first home. When the housing market declines, the newly married couple
gains and the others lose. For example, falling housing sales and prices mean
A- 3
A- 4 Answers
that real estate agents sell fewer houses, at lower prices, so commissions are
lower and their income is reduced. If the housing market is booming and the
economy enters a recession, we can expect that unemployment will rise,
incomes will fall, and sales in housing markets will decline as well.
10. Economic development by individuals in the developing countries means that

their children are more likely to be educated, prosper, and less likely to wage
war with their neighbors. Micro credit (small loans to poverty stricken people
for self-development and small businesses) provides people with a stake in
their communities, reducing poverty and promoting entrepreneurship, leading
to a reduction in individual susceptibility to extremes in political and violent
behavior. As the Nobel committee noted, “Lasting peace can not be achieved
unless large population groups find ways in which to break out of poverty.”
Answers to CourseTutor Homework Questions for Chapter 1

1. c 3. d 5. b 7. b
2. c 4. b 6. d 8. d

1. When there are unemployed resources, and the economy is operating within the
production possibilities frontier.
2. At 2%, the standard of living doubles in 36 years or roughly two generations,

while with a growth rate of 4%, the economy doubles roughly every 18 years or
one generation. The harm is not to the current generation, but to those genera-
tions further out. By the time we go out to your great-great-great grandchildren,
a growth rate of 2% results in a standard of living that is one-quarter of that if
growth is 4%.
Generation Years 2% Growth 4% Growth
1 18 $200
2 36 $200 $400
3 54 $800
4 72 $400 $1,600
3. A straight line PPF curve has constant opportunity costs, whereas the bowed
out (concave to the origin) curve has increasing opportunity costs as the pro-
duction of one good is increased.
Answers A-5
4. a. Florida’s opportunity cost of oranges: 2/50 ⫽ .04, or .04 jar of prickly pear
jelly for each orange. The opportunity cost of a jar of prickly pear jelly:
50/2 ⫽ 25, or 25 oranges must be given up for each jar of prickly pear jelly.
b. Arizona’s opportunity cost of oranges: 100/20 ⫽ 5, or 5 jars of prickly pear
jelly for each orange. The opportunity cost of a jar of prickly pear jelly:
20/100 ⫽ .2, or .2 orange must be given up for each jar of prickly pear jelly.
c. Total combined output for both states will rise to 250 oranges and 500 jars
of prickly pear jelly. This is larger than the sum of any two combinations
available to both states. They will be able to share the excess through trade.
5. a. unemployment
b. unattainable
c. technical advances in shoe production
d. economic growth; increases in resources or factors, or technological
advances in both products
6. Capital goods are those goods used to produce other goods. Producing more
capital goods represents an investment in the economy. This investment leads
to the ability of the country to produce more goods and services in the future.
7. Economies can grow through increases in the quality or quantity of labor, land,
capital, and entrepreneurial activity. Increases in resources expand the PPF
outward. Improvements in technological progress can increase growth in an
economy.
8. Full employment of resources is represented along the PPF. Thus, if the econ-
omy wants to produce more of one product, it must accept less of the other. The
output of one product that must be given up for the increased output of the
other is the opportunity cost of that new production.
9. Costa Rica and Bangladesh, while smaller, have a comparative advantage in the
production of shirts, making it profitable for both countries to specialize and
ship shirts to the United States.
10. Technology will be most important in the how to produce question.
11. Very much the same thing as for individuals. Nations (rich and poor), like fam-
ilies, have limited resources and are unable to do everything a nation would like
to do: providing good roads, communications services, universal health care,
and education for its people.
12. Both China and India have huge labor resources relative to available capital, so
the job is done with a lot of labor and a little capital. The United States has less
labor relative to capital, so wages are higher, and capital is substituted for labor.
13. Any time the economy is operating inside the PPF, some resources will be
unemployed, so any point inside the PPF represents unemployment.
14. No. Scarcity still exists in China. Growth alone does not eliminate scarcity: the
PPF shifts outward, but still there are tradeoffs between products, and time is
still a limited resource for us all. As rich as America is, we still face scarcity.
Economic growth typically does improve standards of living, and the level (or
degree) of scarcity declines.
15. While trade is typically beneficial to both countries in the aggregate, individu-
als and groups within each country lose when their product faces competition
from a country with a comparative advantage.
A- 6 Answers

1. b 5. d 9. d 13. c 17. a
2. d 6. a 10. c 14. d 18. c
3. d 7. a 11. d 15. d 19. d
4. c 8. c 12. b 16. c 20. b

1. Price can be a reflection of quality (albeit imperfectly), and provide businesses
with information about levels of demand. Prices provide consumers with rela-
tive comparisons between products.
2. Demand has increased, but supply has not, so prices are undoubtedly higher.
3. Increase, change in demand.
4. Supply will rise if any of the six determinants of supply change. Improved tech-
nology improves productivity, resulting in more output for lower costs. A
change in quantity supplied results from a change in price, while a change in
supply results from a change in one or more of the determinants.
5. Higher gas prices ($3.00-plus per gallon) increased the demand for compact
(fuel-efficient) vehicles, increasing the rental price. Rising gas prices decreased
the demand for luxury vehicles and SUVs, decreasing the rental rates.
6. The difference is in scaling. Market demands are the horizontal summation of
individual demands. Thus the scale on the horizontal (quantity) axis for market
demands will be huge compared to individual demand curves.
7. The determinants of demand are consumer tastes and preferences; income;
prices of related goods; the number of buyers; and expectations regarding
future prices, income, and product availability. When a determinant changes,
the demand curve shifts.
Answers A-7
Demand Supply
Decrease in Supply
S0
Increase in Demand Change in S2
Quantity Supplied
a Change in c
b Increase in Supply
Quantity Demanded
Price
Price
S1
D1
c
a b
Decrease in D0
Demand D2
Quantity Quantity
8. See the figure above. A change in demand is a shift in the entire demand curve
and is caused by a change in one or more of the determinants. In contrast, a
change in quantity demanded is a movement along an existing demand curve
caused by a change in price. This distinction is important. Say, for example, you
want to distinguish between rising sales at existing prices due to an expanded
advertising program, on the one hand, and rising sales due to a sale or a reduc-
tion in price, on the other hand. A change in supply shifts the curve and is
caused by a change in one or more of the determinants. A change in quantity
supplied is caused by a change in price.
9. The market demand for red wine would increase (shift to the right). More vine-
yards would plant grape varieties that produce red wines rather than white
wines.
10. Markets exist because some people have goods or services that others want. In
this case, some people have little time to play but have money to spend to
enhance their online characters, while other have plenty of time but want (or
need) money. Thus, a market naturally opens up for these virtual characters and
goods. Clearly, supply and demand play a role. It takes time to build and create
characters and to acquire sophisticated weapons in the game. The more diffi-
cult and time consuming any character or weapon is, the fewer will be offered
on the market. In a similar way, the more sophisticated the offering, the more
people will be willing to pay, since it enhances the buyer’s overall success in the
virtual world. If everything were free, probably no one would play the game,
and it is unlikely that there would be a market for characters or weapons.
Assuming that both watches provide the same services (time and date, etc.),
consumers are buying the intangible pleasure of owning a luxury brand. As Rob
Walker asked, “how much of that difference is ‘real’ and how much is essen-
tially in the mind?”
11. a. You would probably increase the prices of existing inventory of surfboards.
You would be expecting a shortage in the short run, and wholesale prices
of foam blanks would probably rise in the future. In fact, most retail outlets
increased the price of their boards from $100 to $300.
A- 8 Answers
b. First, in the very near term, surfboard prices will rise, and the stock of
polyurethane boards will fall. Over time, other companies will supply alter-
native blanks that use alternative processes that avoid the use of TDI.
Currently, epoxy is used along with polystyrene to create a blank, but some
surfers say that these boards are slower in the water. Also, new approaches
to making blanks may emerge. One defense contractor has developed foam
material to protect the electronics in missiles that does not use TDI and is
willing to license this for surfboards.
12. a. Market uncertainty is always a factor on the supply side of any market. The
nuclear power industry was heavily encouraged by the U.S. government
and initially subsidized, but when this encouragement and subsidy were
subsequently withdrawn, the industry suffered considerable losses. Some
polysilicon manufacturers suffered losses in the late 1990s when they
invested in capacity only to see Asia and especially Japan suffer a slow-
down in business.
b. They can wait and make sure that the solar industry is for real, but waiting
can cause them to lose market share in the future. They can reach agree-
ments with solar manufacturers to guarantee a certain level of purchases
from any expanded capacity. They might work with the Chicago
Commodities Exchange to develop a futures market in polysilicon so that
they can hedge their capacity.
13. a. $20 a pound. See graph.
The Market for Vanilla
50 S1
Price ($/pound)
c
40 b
30 S0
a
20
D1
10 D0
D2
0 3 6 9 12 15 18
Quantity (thousands)
Price ($/pound) Demand (D0 ) Supply (S0 ) Supply (S1 ) Demand (D1 ) Demand (D2 )
0 20 0 0 25 4
10 16 6 1 20 3.2
20 12 12 2 15 2.4
30 8 18 3 10 1.6
40 4 24 4 5 .8
50 0 30 5 0 0
b. Supply has been cut by 5/6, so equilibrium price will rise to $40 a pound. See
table and graph.
Answers A-9
c. Coke’s impact on the demand curve is shown in the table and graph; equi-
librium price will be somewhat above $40 a pound.
d. Demand falls to D2, while supply returns to S0; equilibrium price will be
roughly $6 a pound, and equilibrium output will be roughly 3,600 pounds.
14. A growing demand will cause prices to rise as more consumers want what is ini-
tially only a modest available supply. Given the higher prices for premium cof-
fee, more trees will be planted and supplies can be expected to rise in the longer
term. A hard freeze results in lower supplies and higher prices.
15. Oranges and corn are ingredients in many products. Corn appears in nearly all
food products, and oranges are one major ingredient in soft drinks and juices.
Using corn for ethanol will increase its price, and a shortage of oranges will
result in rising prices for drinks and juices. Overall, we would expect food
prices to reflect these rising input prices.

1. c 5. d 9. b 13. d 17. c
2. d 6. b 10. c 14. b 18. b
3. a 7. c 11. b 15. a 19. c
4. d 8. b 12. c 16. c 20. c

1. a. Firms would be willing to devote time and energy (not really compensated
by the PPP approach) because they are motivated by social responsibility
and by concern to enhance their corporate reputation. This might lower
outside pressure on their prices for some of the drugs they have.
b. Several possibilities have been suggested including: broad public limits on
liability for vaccine makers, government indemnification of vaccine makers
for approved vaccines, and a sizable compensation fund for those injured
as part of any bill that limits liability.
c. Governments can agree to buy and stockpile enough to encourage research
and development; they could offer a large prize for the first firm to develop
a cure or significant aid (although this approach has a lot of potential prob-
lems in determining if the first drug should be compensated when a later
drug does a better job); and finally one senator has suggested that drug
firms who develop a product be given a 2-year extension on an existing
patent of their choice.
2. In general the answer is yes. If you eliminate the profit, you eliminate the incen-
tive to sell these goods. This is, however, easier said than done. In some
A- 10 Answers
instances, it may be accomplished fairly easily. For example, if you want to

eliminate illegal immigration, establish a universal ID card and put a large
penalty on employers who hire illegals. Treat illegal narcotics like liquor: legal-
ize, regulate, and tax. While the economic answers are fairly straightforward,
the politics of these measures are not.
3. To some degree it is probably a form of market failure. If consumers and mar-
kets were rational, tips would be based on the quality of service, but they
appear not to be. Even returning customers often do not vary their tips (or over-
tip) based on service. This fact is probably recognition by customers that some
jobs are underpaid, and tips are important and fair to bring the salary up. It is
also a cultural norm to tip.
4. The minimum wage draws attention probably for several reasons. First is polit-
ical: One party —Democratic—is more inclined toward government interven-
tion in the marketplace, and raising the minimum wage is part of its platform.
The Republican party generally favors freer markets, reacts to intervention with
skepticism, and focuses on the unemployment caused by increasing the
required wage above equilibrium. Second, $5.15 an hour seems unfairly low to
many people, and they focus on this unfairness. Third, there is some evidence
that increasing the minimum wage increases other wages as well. Thus, unions
and others are in favor of increasing the minimum wage because this will
enhance their chances of getting wage increases for their members in the
future.
5. Adam Smith suggested that everyone, while working for his or her own inter-
est, unknowingly and without any intention to do so, promotes the public inter-
est as well. We know that markets are efficient and promote consumer interests
as long as externalities, monopolies, and the like are not present.
6. Conferring tenure on professors after a short period of service introduces the
problem of moral hazard. But that problem may be less severe that is often sug-
gested. First, college professors are required to devote a long time in the edu-
cational process to learning specialized knowledge. The alternative would be to
pay very high wages to get people to invest in such specialized training without
job security. Second, senior professors with tenure are expected to hire junior
faculty. Without tenure, they would be hiring competitors for their jobs, and this
would introduce potentially greater problems for the university.
7. Yes. By buying brand names, you are minimizing the information requirements
for shopping.
8. Most consumers would prefer the warranty that gives you your money back in
a specified period. At that point, your choices are greater, and if you have prob-
lems with the current car dealer, you can shop elsewhere.
9. The downside is generally higher prices and farm program bureaucracy with a
budget of over $75 billion.
10. If there were no deadline, only those who stood to benefit immediately would
sign up for the drug benefit. Those who didn’t take drugs or only needed a few
would wait until they faced substantial drug bills and then sign up. This is the
classic adverse selection problem.
Answers A-11
11. Yes, both are consistent with the analysis of price floors set above equilibrium.
A price floor (minimum wage) set above equilibrium results in unemployment.
Second, when the minimum wage is higher, union labor looks relatively more
attractive to firms.
12. Consumer surplus represents the total amount consumers would be willing to
pay for a product over what they actually have to pay. In a similar way, producer
surplus is the total revenue firms receive from selling a product over what they
would be willing to sell it for. Consumer surplus is the area under the demand
curve above equilibrium price (area P0be) shown in the figure below. Producer
surplus is the area above the supply curve below equilibrium price (area 0P0e).
When production costs decline, supply increases to S1 in the figure, which leads
consumer surplus to become larger and expand by area P1P0ea (the shaded
area).
S0
Consumer Surplus
Price
e
P0
S1
a
P1
Producer Surplus D0
0 Q0 Q1
Quantity
13. Public goods are goods that one person can consume without diminishing the
benefits of consuming that good for others (nonrivalry), and once that good is
provided to the market, no one else can be excluded from consuming the good
(nonexclusion). The free rider problem arises because once a public good is
provided, no one can be excluded and one person’s consumption does not harm
others, so many people can consume the good without paying. This free rider
problem would tend to result in private underprovision of the good. Examples
include PBS, NPR, weather forecasts, and national defense.
14. A price ceiling is a legally mandated maximum price that can be charged for a
product or service. An effective price ceiling set below equilibrium price (PC in
the figure on the next page) will cause a shortage. Rent controls are a classic
example. A price floor is a government mandated minimum price that can be
charged for a product or service. An effective price floor set above equilibrium
price (PF in the figure) will result in surpluses. Minimum wages are classic
examples.
A- 12 Answers
S0
Surplus
PF
Price
e
P0
PC
Shortage
D0
0 Q0
Quantity
15. The tragedy of the commons occurs because of the tendency for commonly
held resources to be overused and overexploited. Examples include marine
fisheries, national parks, and freeways that have become clogged. The problem
is that everyone owns the resource, so no one really owns it. Some solutions
include setting limits on use (restrictions on entry into the national parks and
other scenic areas), setting limits on fish catches, and issuing permits. Poaching
of African animals is a problem, and some governments are experimenting with
private ownership as a way to protect the animals.
16. Probably not. Most workers earning the minimum wage are low-skilled
teenagers, getting their first job experience, or other very low-skilled employ-
ees. Expecting low-skilled individuals to earn wages that yield a comfortable
lifestyle is probably unrealistic. Raising minimum wages to the $13 to $16 range
would price many of these workers out of the market.

1. b 5. b 9. b 13. a 17. b
2. c 6. d 10. d 14. a 18. c
3. d 7. c 11. b 15. b 19. c
4. c 8. a 12. b 16. c 20. a
Answers A-13

1. Falls, falls.
2. The demand for gasoline as a whole is relatively inelastic because there are no
close substitutes, gas purchases are a small part of our overall budget, and our
gas-guzzling cars last a long time. Gasoline, given our current lifestyles, is a
necessity. Exxon’s gas is just one brand of many, and if Exxon raises its price,
we will all switch to another brand since gasoline is essentially a commodity
(one brand is as good as another).
3. Cross elasticity of demand measures how responsive the quantity demanded of
one product is to the price of another product. A positive cross elasticity means
that as the price of one product rises, the quantity demanded for the other also
rises. Thus, for example, if the price of beef rises, the quantity demanded of
chicken rises, and beef and chicken are substitutes because chicken is substi-
tuted for beef when its price increases.
Income elasticity of demand measures how responsive quantity demanded is
to consumer income. When consumer income rises, the quantity demanded of
normal goods rises as well, but falls for inferior goods.
4. For firms to expand output in response to price changes requires time: time to
hire more labor, time to order raw materials, and so on. In the market period,
supplies are essentially fixed. In the short run, plant capacity is fixed, but in the
long run all factors are variable. The elasticity of supply will be most elastic in
the long run, less so in the short run, and least in the market period.
5. The elasticity of demand would equal
[(500 ⫺ 400)/(500 ⫹ 400)/2] ⫼ [(.50 ⫺ .60)/(.50 ⫹ .60)/2]
⫽ [100/450] ⫼ [⫺.010/.55]
⫽ .2222/⫺.1818
⫽ 兩⫺1.22兩
⫽ 1.22
Demand is elastic over this price range. When price is 60¢, total revenue
equals 400 ⫻ $.60 ⫽ $240; and when price is 50¢ total revenue is equal to 500 ⫻
$.50 ⫽ $250, so total revenue will rise.
6. a. When price rises and total revenues fall, the demand is elastic.
b. When price is $7 a unit and total revenue is $700, 100 CDs must be sold
($7 ⫻ 100 ⫽ $700). When price rises to $8, 80 units are sold ($8 ⫻ 80 ⫽
$640). Thus, the value of elasticity (using the midpoint formula) is
(⫺20/90) / (1/7.5) ⫽ ⫺.2222 / .1333 ⫽ ⫺1.667
7. a. When coffee prices rise and donut sales fall, cross elasticity will be nega-
tive and these are complements. The cross elasticity of demand (using the
midpoint formula) is
(⫺100/900) / (10/94) ⫽ ⫺.1111 / .1064 ⫽ ⫺1.044
A- 14 Answers
b. When the local Cinnabon franchise drops the price of cinnamon rolls and
the sales of Dunkin’ Donuts donuts falls, the cross elasticity of demand will
be positive and these two goods are substitutes. The cross elasticity of
demand (using the midpoint formula) is
(.20/1.79) / (100/800) ⫽ .1117 / .125 ⫽ .894
8. With inelastic demand for agricultural products, a big increase in supply would
reduce total revenues to farmers. Unless the total cost to farm dropped, farm-
ers’ net incomes (net of costs) would fall. Farm productivity has actually grown
dramatically as described.
9. The cross elasticity of demand is 10/15 5 .67, so they are substitutes.
10. A negative cross elasticity of demand means the goods are complements.
Therefore, (a), (b), and (e) are the only complements.
11. Business travelers have less flexibility (they need to solve some problem or
make a sale tomorrow) and typically decide to travel with a shorter time hori-
zon than do retirees who can travel when they can get better prices.
12. Since the mayor seems to be saying that London can increase the charge by 60%
and see total revenues rise, the mayor must be assuming that the demand is
inelastic, at least in the short run. Over a longer time horizon, individuals will
find other ways to enter the central city, and the demand will become less
inelastic.
13. The amount of dental services will decline by 8%, but the total spent on dental
care will grow.
14. He is undoubtedly correct. The short-term elasticity of demand for crude oil is
inelastic compared to longer-term demand because in the long-term consumers
can adjust to higher prices by employing substitutes: mass transit, car pools,
more fuel efficient automobiles, fewer trips, and the like.
15. a. Total revenue is maximized with a ticket price of $4.00.
b. Total ticket sales at $2.50 is 55, and when price drops to $2.00, sales rise to
60 in the sample. Elasticity of demand is
(60 ⫺ 55) / [(60 ⫹ 55)/2] 5 / 57.5 .087
Ed ⫽ ᎏᎏᎏᎏ ⫽ ᎏᎏ ⫽ ᎏ ⫽ 兩⫺.395兩 ⫽ .395
(2.00 ⫺ 2.50) / [(2.00 ⫹ 2.50)/2] ⫺0.5 / 2.25 ⫺.22
c. Bowling and attendance at night baseball are substitutes, so the cross elas-
ticity will be positive. Yes, it will affect attendance because some of the fans
will be bowling.
16. a. They must have assumed that demand was relatively inelastic. They must
feel they have a strong brand.
b. First, 100,000 ⫻ $48 ⫽ $4,800,000, and thus, $4,800,000 ⫼ $88 ⫽ 54,545
sweaters to generate the same revenue. Elasticity of demand is equal to
(100,000 ⫺ 80,000) / [(100,000 ⫹ 80,000)/2] 20.000 / 90,000 .22

Ed ⫽ ᎏᎏᎏᎏᎏ ⫽ ᎏᎏ ⫽ ᎏ
(48.00 ⫺ 88.00) / [(48.00 ⫹ 88.00)/2] ⫺40 / 60 ⫺.67
⫽ 兩⫺.33兩 ⫽ .33
Answers A-15
17. a. Neither would be very responsive in the market period.

b. Both can hire extra employees, but computer chip manufacturers need to
hire and train new employees, and this will take longer for them than for
potato chip firms.
c. Computer chip factories are extremely expensive (approaching one billion
dollars) and take a long time to obtain permits, build, and make ready for
production. They must locate where a skilled labor force is available and
where high-skilled high-tech workers want to live. Potato chip manufactur-
ing is not done on the same scale, and the time to increase production is
much less.
18. a. [(1000 ⫺ 992)/(1000 ⫹ 992)/2] ⫼ [(1.25 ⫺ 1.26)/(1.25 ⫹ 1.26)/2] ⫽ [8/996] ⫼
[⫺.01/1.255] ⫽ ⫺.008/.008 ⫽ ⫺1.0
b. Inelastic
c. Elastic
19. An income elasticity of demand of 1.5 suggests a luxury brand like BMW or
Mercedes. The car with the income elasticity equal to ⫺0.3 would be an “infe-
rior good” brand like the Geo Metro or other inexpensive brands.
20. When the cross elasticity estimate is 2.3, these products are close substitutes;
for 0.1, the products are really unrelated; and a value of ⫺1.7 would represent
complements. To find out if the products of two firms compete in the market,
we would look for a positive cross elasticity number: the higher the number, the
more competitive the products (substitutable).

1. c 5. b 9. b 13. a 17. c
2. c 6. d 10. d 14. d 18. d
3. d 7. a 11. a 15. a 19. c
4. d 8. b 12. c 16. d 20. a

1. Utility is maximized when the marginal utility per dollar of each product con-
sumed is equal. If you received 5 utils per dollar for one product and only 2 for
another, total utility would be increased by consuming more of the first product
and less of the second. This weighing process would continue until you no
longer could gain by choosing one product over another.
2. a. At $5 a unit for both products, the consumer will buy 2 units of each product.
b. When the price of product B rises to $10, the combination will be 2 units of
A and 1 unit of B. The first unit purchased will be a unit of A (20/5 5 4), the
A- 16 Answers
second unit purchased will be a unit of B (30/10 5 3), and finally the last $5
will be spent on a second unit of A (10/5 5 2).
c. If the price of both products rises to $10, one unit each of A and B will be
purchased.
3. You have consumed so much of a product that you are essentially satiated. You
still received utility from your total consumption, but if you consumed one
more unit, the marginal utility would be negative and total utility would fall,
though still would be positive. This is the typical outcome from an all-you-can-
eat buffet. You enjoy the meal, but eat so much that the extra dessert makes you
feel bad for hours.
4. a.
First-Run Movie Wine (bottle)
Marginal Marginal
Utility per Utility per
Total Marginal Dollar Total Marginal Dollar
Quantity Utility Utility (P = $10) Quantity Utility Utility (P = $10)
0 0 0 — 0 0 0 —
1 140 140 14 1 180 180 18
2 260 120 12 2 340 160 16
3 360 100 10 3 460 120 12
4 440 80 8 4 510 50 5
5 500 60 6 5 540 30 3
b. With the prices at $10 each, you will go to 2 movies and drink 3 bottles of wine.
c. When the price of wine falls to $5 a bottle, you will go to 3 movies and drink
4 bottles of wine.
d. Price of wine has fallen from $10 to $5, and quantity demanded has risen
from 3 to 4 bottles. Using the formula from Chapter 5, elasticity of demand
is equal to (1/3.5) ⫼ (⫺5/7.5) ⫽ .286/⫺.667 ⫽ 兩⫺.43兩 ⫽ .43
5. Terrorism is the quintessential ambiguous risk with unknown odds, and this
insight helps to explain why it strikes so much fear into people. Air travel and
many other activities have potential lethal effects, but the probability is well
known and may be no higher than that of being involved in a terrorist incident.
6. No, it doesn’t seem rational. Waiting a week to get $15 more is a huge return (in
annual percentage terms) compared to waiting one more week after a year.
Rational choice would suggest you would wait a week for $15 more, compared
to waiting one more week after a year. A decision that is significantly in the
future will not seem as immediately important and is more likely to get a thor-
oughly reasoned approach. Thus, long-term decisions may well fit the marginal
utility and indifference curve framework better.
7. Luxury-goods consumers are not irrational. Price may be an important charac-
teristic of luxury goods. Luxury consumers may want to flaunt their wealth, as
suggested by Thorstein Veblen in his book, The Theory of the Leisure Class.
The marginal benefit from the product may drop off quickly when everyone can
afford it if a large part of the benefit may come from conspicuous consumption.
Answers A-17
8. Not necessarily. The empirical data presented by Professor Layard does suggest
a high positive correlation of happiness with per capita income below $20,000,
suggesting that additional income when you are poor yields greater utility. One
problem with this approach (relating happiness to income) ignores the income
distribution question. Income per capita may be high, but if the vast bulk of
income is in a few hands, the measures may mean less. Finally, since measuring
utility is impossible, it is difficult to compare individuals; it is possible that Bill
Gates gets just as much marginal utility out of his next $100 as you or I.
9. Ads don’t go away—they just change forms. Ad agencies realize this trend is
happening, and they are trying a host of new techniques such as product place-
ments within the program itself, in which your favorite TV show has characters,
say, driving Ford cars and drinking Starbucks coffee. Sometimes, ads build on
this placement and look like a continuation of the show. Additionally, more ad
money is moving to alternative media: the Internet, cable, and sponsoring of
events.
10. When the product choices are narrowed to two, and the prices are similar, the
marginal utility framework seems to provide a reasonable guide to consumer
decision making.
Sample Chapter 6 Appendix Answers

1. The equilibrium points are shown in the graph below.
5
First-Run Movies
b
3
a I2
2
1
I1
I0
0 1 2 3 4 5 6 7 8 9 10
Bottles of Wine
2. If you have indifference curves that intersect, then you have two different indif-
ference curves passing through the same point. At that point, the two curves
would be indifferent, but that cannot be since each indifference curve repre-
sents a different level of satisfaction. Two indifference curves cannot have the
same level of utility.
3. The first two bundles are fine, but the last bundle (4A, 3B) must necessarily be
preferred to the first (4A, 2B), since it has the same four apples, but one more
banana.
A- 18 Answers
Marginal Utility Analysis

1. d 4. c 7. d 10. c 13. d
2. d 5. d 8. d 11. b 14. b
3. c 6. a 9. c 12. b 15. c
Indifference Curve Analysis

1. a 3. b 5. b 7. b 9. b
2. c 4. a 6. d 8. a 10. d

1. Explicit costs are those out-of-pocket expenses paid to others, while implicit
costs are opportunity costs. Economic profits are profits after both explicit and
implicit costs are deducted, while accounting profits typically do not have
implicit costs deducted. The four concepts are related in how they are defined,
with implicit costs playing an important role.
2. a.
Labor Output Marginal Product Average Product
0 0 0 —
1 7 7 7.00
2 15 8 7.50
3 25 10 8.33
4 33 8 8.25
5 40 7 8.00
6 45 5 7.50
b. Up to three workers.
c. With the fourth worker.
d. No.
3. In the short run, one factor of production is fixed, but in the long run all factors
can vary, and firms can enter or leave the industry. The long run differs for
industries and firms because the time required to expand plant capacity differs
Answers A-19
among industries. Some industries are heavily regulated (chemical and nuclear
power plants), while others are not (restaurants and retail establishments), and
these regulations take more or less time to fulfill.
4. a.
L Q MP AP TFC TVC TC ATC AVC AFC MC
0 0 0 0 100 0 100
1 7 7 7 100 80 180 25.71 11.42 14.28 11.42
2 15 8 7.5 100 160 260 17.33 10.66 6.66 10
3 25 10 8.33 100 240 340 13.60 9.60 4 8
4 40 15 10 100 320 420 10.50 8 2.50 5.33
5 45 5 9 100 400 500 11.11 8.88 2.22 16
6 48 3 8 100 480 580 12.08 10 2.08 26.66
7 50 2 7.14 100 560 660 13.2 11.20 2 40
b.
45
40 MC
35
30
25
20
15
ATC
AVC
10
5
AFC
0
0 10 20 30 40 50 60
5. Zero or near zero. They simply need to maintain a database of users.

6. As a firm expands its output, economies of scale are encountered due to spe-
cialization of labor and management. Eventually, a flat region is reached,
reflecting the fact that the firm can duplicate its operations at virtually the same
cost. Finally, the firm gets so big that it begins to lose control, and costs begin
to rise.
A- 20 Answers
7. a. fixed, b. fixed, c. variable, d. variable, e. variable, f. variable, g. variable, h.

fixed, i. variable
8. Accounting profits are the difference between total revenues and explicit costs
and a few implicit costs such as depreciation and depletion (tax and account-
ing rules allow for deduction of these particular implicit costs). Economic prof-
its are equal to total revenues minus all economic costs both explicit and
implicit, including both the opportunity cost of the entrepreneur and the firm’s
cost of capital.
9. Sunk costs by definition have been spent and cannot be retrieved. Decision
making is about the future, and therefore sunk costs are irrelevant to future
decisions. How much money you spent on insurance last year has nothing to do
with whether you should purchase insurance this year.
10. Since fixed costs are fixed, total fixed costs do not vary, so as more output is
produced, average fixed costs continue to fall as the Q in TFC/Q gets larger.
11. Average fixed cost.
12. If marginal cost is less than average total cost, then average total cost is falling
and vice versa. A baseball player hitting .333 (gets a hit one-third of the time on
average) will see his average rise when he gets a hit and fall when he does not.
If the average income of your class is $15,000 (some people work), and Tom
Cruise decides to take a refresher course in economics and joins your class,
average income rises, and vice versa if someone with no income joins the class.
13. Marginal cost is the change in total variable cost divided by the change in out-
put or the cost associated with producing additional units of production. Thus,
if an additional worker costs (or wage is) $200 a day, and marginal productivity
(the additional output associated with this new hire) is 10 units (marginal prod-
uct), the marginal cost for each of these 10 units is $20 ($200/10). So the rela-
tionship between marginal costs and marginal product is the formula MC 5
wage/MP.
14. Yes, it seems to be a little hyperbolic. Clearly, with information and the Internet,
economies of scale and scope may matter less than in manufacturing. But still,
many large organizations generate a lot of content, and this content is in high
demand on the Web-generating economies. Further, most of the products and
services we consume are subject to huge economies: air travel, food, clothes,
cars, and so on.
15. They are fixed costs; they are unrelated to output. Initial public offerings repre-
sent new firms going public. They raise capital to expand, and they now are sub-
ject to government oversight that previously didn’t apply to them as a private
company. All countries have corporate laws that are similar, but Sarbanes-
Oxley added a significant layer of constraints on business and reporting
requirements that these new companies are avoiding. Yes, the NYSE and NAS-
DAQ will undoubtedly be seeking foreign stock exchanges. In fact, in early
2006, ARthurNASDAQ was trying to buy the London Stock Exchange (LSE).
Answers A-21

1. d 5. b 9. c 13. a 17. b
2. a 6. c 10. c 14. c 18. c
3. d 7. d 11. a 15. d 19. d
4. c 8. a 12. b 16. c 20. c

1. a.
L Q MP AP TFC TVC TC ATC AVC AFC MC
0 0 0 0.00 100 0 100
1 7 7 7.00 100 80 180 25.71 11.42 14.28 11.42
2 15 8 7.50 100 160 260 17.33 10.66 6.66 10.00
3 25 10 8.33 100 240 340 13.60 9.60 4.00 8.00
4 40 15 10.00 100 320 420 10.50 8.00 2.50 5.33
5 45 5 9.00 100 400 500 11.11 8.88 2.22 16.00
6 48 3 8.00 100 480 580 12.08 10.00 2.08 26.66
7 50 2 7.14 100 560 660 13.20 11.20 2.00 40.00
b.
45
MC
40
35
30
25
20
15
ATC
AVC
10
5
AFC
0
0 10 20 30 40 50 60
A- 22 Answers
c. At $16 a unit, MC ⫽ MR ⫽ P at 45 units of the product. Total profit is TR ⫺

TC, and TR ⫽ $16 ⫻ 45 ⫽ $720. Total cost is $500, so total profit is $220.
d. At a price of $10.50, the firm’s total revenue and cost are equal at $420, and
the firm earns a normal profit (economic profit ⫽ 0).
e. The price of $7.50 falls below the minimum point on the AVC curve, so the
firm will shut down, and its losses will equal fixed costs ($100).
2. These firms typically suffer short-term losses due to what they view as tempo-
rary changing conditions in their markets or from new competition. Since the
losses are smaller than the costs of shutting down (fixed costs), they continue
to operate and try to react to the problems.
3. If price is less than average variable costs, then losses will exceed fixed costs
than if the firm closed its doors. If price cannot cover the costs of the variable
factors of production, then the firm should close its doors. Thus the loss per
unit of the product would be (AVC – P) + AFC. Since P < AVC, then losses are
greater than AFC times output (or TFC).
4. Easy entry and exit are crucial in the long-run adjustment process in competi-
tive markets. When existing firms are earning economic profits, entry is encour-
aged, bringing prices down and returning industry profitability to normal. Just
the opposite occurs when existing firms are earning losses. Some of the exist-
ing firms leave the industry, reducing supply, resulting in higher prices and
bringing profits up to normal levels.
5. a. T; at $25 a unit the firm produces 100 units and P > ATC, so the firm earns
an economic profit.
b. F; at $20 per unit, the firm will sell 100 units, and at that output, ATC is
roughly equal to $16, so profit per unit is $4, and thus economic profit
would be about $400.
c. F; at $9 a unit, P < AVC, so the firm will shut down.
d. T; at $12.50, P = MC at roughly 70 units, and loss per unit is roughly $2.50,
so economic losses are $2.50 3 70 ⫻ $175.00.
e. F; TFC = AFC ⫻ Q, so at output of 60, for instance, AFC is roughly $6, so
TFC = $6.00 ⫻ 60, which equals roughly $360.
f. T; a price of $15 is just tangent to the minimum point on the ATC curve, so
the firm earns a normal profit by producing 80 units.
6. Competitive firms are all so small relative to the market that they alone cannot
affect the market. If they try to increase their prices, they will sell nothing as
consumers will buy their standardized (homogeneous) products elsewhere. If
they lower prices, they will sell their production, but earn less. Thus, competi-
tive firms are price takers.
7. Marginal revenue is equal to the change in total revenue from selling another
unit of the product. For competitive firms this is just equal to market price. This
is a simple concept for competitive firms, but it becomes more complex for the
other market structures, as we will see in the next two chapters.
8. Profit maximization requires that firms produce output where MR = MC. For
competitive firms this is where P = MC, since P = MR. The firm will produce
nothing (shutdown) if P < AVC and will produce output where P = MC if P ⱖ
AVC. Therefore, the competitive firm’s supply curve is the output associated
with the MC curve for P ⱖ AVC.
Answers A-23
9. In the same way that honey attracts bears, short-run economic profits attract
new firms to the industry in the long run. These new entrants increase market
supply, lowering prices and reducing profits to normal.
10. In general, the Internet has resulted in more small firms (and people) entering
the business of selling both used (and new) books and antiques. Web sites such
as Amazon.com, Half.com, and eBay.com have significantly reduced the entry
costs. The result has been that many used books and antiques have fallen in
price as supply has greatly increased over the last decade.
11. It would be hard to argue that the growth of the Internet has not fostered more
competitive markets as the competitive theory would predict. Easy entry and
exit and a growing number of online merchants along with improved informa-
tion with price comparison sites have all added to the competitiveness of many
markets and industries. All prices are not the same, since there are still risks
and different levels of service on the Internet. This is a case, however, where
the competitive model’s predictions generally seem to have been borne out.
12. The two characteristics that seem to be most important at this point are the
number of buyers and sellers and the level of barriers to entry and exit. The
nature of the product and control over price (which comes with a lower num-
ber of sellers and the extent of barriers to entry) seem secondary.
13. Costs may increase in the long run if expanding the industry bids up resource
or input costs. Costs might decline in the long run because of technological
advances or if industry growth permits suppliers to gain economies of scale.
14. If the ATC curve shifts downward by $5, existing firms will now be making eco-
nomic profits equal to roughly $5 a unit in the short run. New firms will enter
the industry, industry supply will rise, and the new equilibrium will be achieved
at a price $5 less than before the technological change.
15. A competitive firm maximizes profit where P ⫽ MR ⫽ MC. If price is greater
than ATC, then the firm is producing more output than that associated with the
minimum point on the ATC curve. Maximum profit per unit is at that output
where ATC is at a minimum (profit per unit ⫽ P ⫺ ATC). Beyond that point,
ATC is higher and rising, so profit per unit will be less, but total profit will
increase until it is maximized at the output where MR ⫽ MC.

1. c 5. c 9. a 13. d 17. b
2. d 6. a 10. d 14. a 18. c
3. d 7. d 11. c 15. c 19. b
4. c 8. c 12. c 16. d 20. d
A- 24 Answers

1. Neither are monopolies in the strictest sense, although each has monopoly
power. Both exploit location well. In their local realm they have considerable
monopoly power, but in both cases there are numerous competitors a short
drive away.
2. De Beers has had a virtual monopoly on diamonds up to a few years ago. Their
response to synthetic diamonds will be to advertise something such as, “Only
the authentic ones will do. She will know. Don’t be such a cheapskate.”
3. Significant or nearly impossible barriers to entry are vital to maintaining a
monopoly. Without such barriers new firms could (and would) enter, driving
prices lower and profits toward normal. Technology is changing so rapidly in
these areas that what might be a monopoly today is rendered less so when the
next new thing is introduced.
4. Competitive firms are so small they only have a negligible impact on the mar-
ket, so they take their price from the market and adjust output to maximize
profits. So for each unit produced, MR ⫽ P. Monopolists, on the other hand, are
the market. Their demand is industry demand. To sell more output, they must
lower market price not only to new customers, but to all customers, so their
MR ⬍ P.
5. Monopolies are inefficient because monopoly output is lower, and prices are
higher when compared to competitive markets. The deadweight loss to monop-
oly is the consumer and producer surplus lost because prices are higher and
output is less under monopolistic conditions (see Figure 5).
6. a. MR ⫽ MC where output is 50 million units. From the demand curve, price
will be $45, and total profits will equal $750 million [TR ⫺ TC ⫽ ($45 ⫻ 50
million) ⫺ ($30 ⫻ 50 million)] ⫽ $750 million.
b. If the monopolist could perfectly price discriminate, total profit would
equal the area under the demand curve above the MC curve. Thus profit is
equal to [($60 ⫺ $30) ⫻ 100 million] ⫼ 2 ⫽ $1,500 million.
c. If this were a competitive industry, P ⫽ MR ⫽ MC would be the profit max-
imizing output at 100 million units, price would equal $30, and economic
profit would be zero.
d. The deadweight loss is equal to the area under the demand curve above the
MC curve between the competitive output and monopoly output. Thus, the
deadweight loss would equal [($45 ⫺ $30) ⫻ (100 million ⫺ 50 million)] ⫼
2 ⫽ $375 million.
7. a. Monopoly output would be roughly 140 million units, with a price of $42.
Economic profit would equal ($42 ⫺ $31) ⫻ 140 million ⫽ $1,540 million.
b. If regulators required that P ⫽ MC, then output would be roughly 330 mil-
lion with P ⫽ MC of $26. At an output of 330 million, the difference between
ATC and P is roughly $9, so the total subsidy would have to be $9 ⫻ 330 mil-
lion ⫽ $2,970 million.
c. Using P ⫽ ATC as the regulatory approach would lead to output of 260 mil-
lion, with a price of roughly $25, and economic profits would be zero.
8. Yes, innovation in the tech sector is paramount. Barriers to entry are relatively
low. Today’s big fast growing firms Google, eBay, and Yahoo were started on a
Answers A-25
shoestring, but now they innovate to survive. Nearly all of these firms face a
growing threat from the open source industry that spawned Linux.
9. Probably not. By giving the other firms 4–5 years notice, existing competitors
will be able to locate new supplies either by producing their own or other sup-
pliers will ramp up production. The long time frame was probably used to pre-
vent any antitrust action from the Swiss government.
10. Wal-Mart is tough competition for union-organized grocery stores and other
large enterprises such as Kmart, Safeway, and regional retailers. Lobbying
states to enact legislation that increases Wal-Mart’s costs is a form of rent seek-
ing by competitors. Labor unions have unsuccessfully tried to unionize Wal-
Mart. This is an alternative approach to reducing Wal-Mart’s ability to expand
and keep costs below the competition.
11. In 1960, General Motors, Ford, and Chrysler were essentially the market—the
Big Three. A merger then would have been unthinkable. Today, there are many
other competitors, and all three firms are having trouble, so it might pass
merger authorities.
12. As the quote suggests, number two firms fly under the radar. Another important
benefit is that these firms are usually ignored for antitrust actions, and often
they can merge with other firms with very little attention unless the difference
between them and the top firm is trivial. For 2005, the number one, two, and
three firms in several industries (data for 2005 sales in billions of dollars is in
parentheses) was
Auto Manufacturers—Major:
Daimler Chrysler ($200.4B)
General Motors ($199.1B)
Toyota ($183.3)
Semiconductor—Broad Line:
Intel ($38.3B)
Texas Instruments ($14.0B)
STMicroelectronics ($9.2B)
Drug Manufacturers-Major:
Pfizer ($50.9B)
Johnson & Johnson ($50.7B)
Glaxo Smith Kline ($42.5B)
Banks:
Citigroup ($76.9B)
Bank of America ($56.0B)
JP Morgan Chase ($52.2B)
Major Integrated Oil & Gas:
Exxon Mobil ($338.6B)
British Petroleum ($265.4B)
Chevron ($198.4B)
13. They would probably rise, but not to the level of a monopolist because satellite
services provide nearly perfect substitutes for cable TV.
14. Yes, Professor Glaeser has a point. The more restrictive zoning and building
codes are, the higher new housing will cost. Some cities like Houston, Texas,
A- 26 Answers
have minimal zoning restrictions, and housing costs are relatively lower as a
result (but this is not the only reason). By giving current residents more say
over new development, this often means development will be severely
restricted, resulting in rising prices. The point of this question is that monop-
oly analysis often shows up in unexpected places, and even though we all dis-
like monopolists, we may find ourselves acting like them when it suits our
self-interest.
15. After the merger, if the HHI is under 1,000, the industry is unconcentrated, and
the Justice Department would be likely to permit a merger. In the table, this
would be dental labs and office furniture. Pharmaceutical manufacturing and
petroleum refining would probably have postmerger HHIs below 1,000, but
unless this merger involved two very small firms, there would be significant
political pressure to restrict a merger given the nature of the industries.
16. Dental labs tend to be local by necessity; dentists do not want to send models
long distances. Also, capital costs are relatively small and entry is easy.
17. Unless it was two small firms in the industry, aircraft engine, electric lamp, and
electronic computing would be rejected since their HHIs are over 2,500.
Household vacuum cleaner mergers would probably be rejected as well.
Mergers of two small firms can increase competition in any industry, and these
mergers are often allowed even in relatively concentrated industries because
this often results in another viable competitor to the larger firms at the top.

1. a 5. d 9. d 13. a 17. b
2. c 6. b 10. b 14. b 18. a
3. d 7. c 11. c 15. c 19. c
4. d 8. b 12. c 16. d 20. d

1. Monopolistic competition involves differentiated products. Economic profits in
the short run attract new firms, reducing individual firm demands until only
normal profits are earned by all industry firms.
2. Rivals will not follow price increases, but will match any price reductions. This
leads to a kink in the demand curve at market price. The kink in the demand
curve results in a discontinuity in the MR curve, so MC can vary and market
price remains constant.
Answers A-27
3. A few firms relative to the market and few enough that each firm must consider
the reactions of its rivals. Significant barriers to entry and mutual interdepend-
ence characterize oligopoly.
4. First, the government felt Microsoft was abusing its monopoly position in oper-
ating systems to the detriment of competition in other areas (Internet browsers
and the players for audio files). Although Google currently has a large market
share of search activity and the associated revenues, plenty of big firms are nip-
ping at their heels (MSN, Yahoo, and others). Strategic behavior analysis and
game theory like that discussed in this chapter probably played a role in the
government’s decision.
5. Monopolists can maximize profit over the entire industry, whereas oligopolists
only have a portion (presumably large) of the market. Oligopolists have fewer
competitors and are able to achieve greater sales revenues and profits than
monopolistic competitors.
6. Clearly monopolistic competition has elements of both market structures, but
monopolistic competition is much more like competition, and the monopolistic
elements are relatively minor. Many buyers and sellers, and no barriers to entry
or exit, are conditions that are more important than the small levels of monop-
oly power resulting from product differentiation.
7. Mutual interdependence means that firms must take their competitors’ reac-
tions into account when making their own decisions. This is not really a factor
in the other three market structures. Because rivals’ reactions must be consid-
ered, and humans and firms are unique, this opens up a huge number of possi-
ble models for oligopolistic industries. This element of oligopoly partly led to
the development of modern game theory.
8. Yes, globalization makes domestic concentration estimates suspect and less
meaningful and probably explains why there is significantly less government
antitrust litigation today. While firms in oligopolistic industries are huge,
because of globalization and foreign competition, a good argument can be made
that these industries act more like monopolistic competitors today. Very few
industries have the price and profit stability the old-line oligopolies had in the
past.
9. Oligopolistic industries tend to have significant barriers to entry and exit. For
example, to enter the computer microchip–fabricating business (i.e., to com-
pete with Intel and AMD) requires huge capital expenditures on plant, equip-
ment, and expertise. A typical Intel fabrication plant alone can cost over a bil-
lion dollars to get up and running.
10. Repeated games can take into account the past behavior of rivals and punish or
reward that behavior with the intent of changing future behavior.
11. The ATC curve does not change. Existing firms’ demand declines and shifts to
the left. Profit declines along with dropping demand.
12. Cartels typically set prices by joint profit maximizing and then allocate the per-
missible output to members. Since prices are set at roughly monopoly levels,
this leaves a lot of potential sales (and profits) at prices above marginal costs if
a cartel participant is willing to cheat. This profit incentive to cheat undermines
cartel stability.
A- 28 Answers
13. The Attorney General might have used a Prisoner’s Dilemma game like the one
below to argue the case.
Payoff Matrix for P&G and Its Competitors

Other Firms
P&G No coupons Coupons
No coupons $10,000,$10,000 $8,000,$12,000
Coupons $12,000,$8,000 $9,000,$9,000
If both P&G and the other firms don’t offer coupons, they earn $10,000 profits
each, but the minimax solution is that both offer coupon programs. The only
way P&G could get away disbanding its coupon program is if the other firms did
not, and that is not in their best interest. Hence, the suspicion of collusion.
14. Export Trading Companies, as they are formally known, were designed to per-
mit smaller firms to get together in a marketing and distribution organization to
encourage economies of scale and exports. Small firms typically do not have
the expertise or capital to enter foreign markets. By combining into a trading
company, common prices could be set, and marketing, distribution, and cus-
toms clearances would reduce costs. The cartels or export companies were
designed to stimulate U.S. exports.
15. Since my wife was ready at 6:00 A.M. to order online, the suspicion is that not
many good seats were released early since those willing to get up and order
online early on the opening day must really want to go. As a result, they can be
directed to less desirable seats, and they will buy them. These seats are harder
to sell later, and empty seats are pure profits lost.

1. a 5. b 9. d 13. b 17. d
2. d 6. c 10. b 14. c 18. c
3. c 7. d 11. c 15. d 19. d
4. d 8. d 12. d 16. b 20. d

1. The decision to have children typically means that the mother (as the primary
caregiver) will leave the labor force, even if only temporarily, resulting in lost
wages and a reduction in career activities. Working part-time reduces the mon-
etary loss. Being out of the labor force for an extended period means that an
attractive career ladder has been interrupted and lifetime earnings are reduced.
Answers A-29
2. Clearly, the United States and Europe, facing the same problems, will be com-
peting to bring high-skilled foreign workers into the country to replace retiring
baby boomers. This will also be a rational response given the deficits facing
Social Security and Medicare partly because of these aging baby boomers.
Higher-skilled workers are paid more and contribute more to these programs
than they get back in benefits. To encourage older workers to stay, firms can
make work more ergonomic, flexible, and offer part-time positions.
3. First, creating “nicer” jobs involves costs, and these costs must be balanced
against the benefits of lower wages. Second, not all jobs can be made nicer.
Some construction, mining, and security positions are dangerous, dirty, or a
combination of the two. Some adjustments are profitable, such as “job splitting”
(where two people share one full-time job), flextime, and telecommuting from
home.
4. Since time is a limited resource for all of us, the time required to do work at
home such as preparing meals, doing laundry, and so on, has declined as home
appliances have become more efficient. Meal preparation time has also been
reduced by technology. The passage of fair wage and labor laws reducing wage
discrimination has played a role because higher wages make work more attrac-
tive to women. The same is true for reducing marginal tax rates. This means
women, who are often secondary workers, can take home more of a given
salary. Finally, social norms have changed regarding mothers and working. This
has been met by a jump in child care facilities.
5. Dual-earner households have less time to spend preparing meals, so dining out
probably represents a substitute. These families may be partially responsible
for the rapid growth in demand for dining out and the growth in the restaurant
industry.
6. The United States has benefited handsomely from high-skilled immigrants over
the years, including Albert Einstein and other familiar names. Security tradeoffs
are the biggest obstacles—checking people’s background requires a lot of
employees. Letting in unlimited numbers of immigrants would be a political
risk, because a large flow of high-skilled workers would lower wages for a large
section of Middle America. This is a major obstacle to a policy that could cause
a serious short-term brain drain from developing nations.
7. When the economy is booming, capital investment grows as well. Recessions
discourage investment because income is down (or growing slowly), and
demand for products falls. When the demand for capital rises, interest rates will
rise, and this will dampen investment. During recessions, interest rates fall,
helping to stem the decline in investment.
8. When wages rise and you substitute work for leisure, the substitution effect is
operating: Leisure has become more expensive and work is substituted for it. If
wages rise high enough, you can earn what you want to support a given
lifestyle, so the income effect becomes more important, and you work less and
take more leisure time. The substitution effect results in more work with a ris-
ing wage, whereas the income effect results in less.
9. As you probably remember from an earlier chapter, monopolies produce less
and sell their product at a higher price than competitive industries. Producing
less means you will need fewer workers. Firms hire labor where MRP ⫽ W, and
MRPL ⫽ MPPL ⫻ MR. For competitive firms, P ⫽ MR, and for monopolies,
A- 30 Answers
P ⬎ MR, so the MRPL for monopolies is less than for competitive industries,
and thus monopolies hire fewer workers.
10. Most college professors teach 200–300 students a year and have a positive
impact, but the market judges their marginal revenue product as roughly equal
to their salaries. Jerry Bruckheimer, however, produces movies and television
programs (e.g., Top Gun, Beverly Hills Cop, Black Hawk Down, and Pirates of
the Caribbean, and TV shows such as the various CSI series and Cold Case)
watched by millions, and the market judges his marginal revenue product quite
highly. Also, many people can teach college, but few can do what Bruckheimer
can do: consistently produce successful films and TV shows.
11. For some professors in departments such as finance, accounting, and engineer-
ing, broader market salaries are high. If the university simply paid an average
wage to all, recruiting people to teach in these areas would be nearly impossi-
ble, or the quality of faculty hired would suffer.
12. Yes, when business faces expensive labor, it will often innovate and substitute
new technology and capital for labor. When labor works with technology or
more capital, productivity rises along with wage rates. Flooding a market with
unskilled workers would likely result in less capital employed, as well as lower
productivity and wages.
13. Yes, it is consistent with the competitive labor market outlined in the chapter.
A reduction in supply of unskilled labor would drive up wages, and to the extent
that unskilled wages rise relatively faster than skilled wages, inequality could
be reduced.
14. The present value of the bond today is
PV ⫽ $1,000 ⫼ (1 ⫹ .06)2
⫽ $1,000 ⫼ [(1.06) ⫻ (1.06)]
⫽ $1,000 ⫼ 1.1236
⫽ $890.00
15. Anything that increases the demand for the products labor is producing, any-
thing that increases labor’s productivity, and an increase in the cost of capital
means labor will be substituted for capital.
16. a. ($12.50 ⫻ 2,000) ⫻ 30,000 ⫽ $750,000,000
b. ($20.00 ⫻ 2,000) ⫻ 45,000 ⫽ $1,800,000,000
c. [($25.00 ⫺ $12.50) ⫻ 2,000] ⫻ 30,000 ⫽ $750,000,000
d. The firm is a competitor in the product market since its demand for labor
is the VMP of labor.
17. Individuals make tradeoffs between labor and leisure. As wage rates rise, ini-
tially the substitution effect dominates, and workers substitute work for
leisure. But as wages rise to high levels, additional income is less important
since these high wages yield high incomes with less work; and so the income
effect dominates, resulting in workers substituting leisure for work: Thus, the
supply curve bends backward. Market and industry labor supply curves do not
bend backward since higher wages in one market (industry) elicit supplies from
other industries.
Answers A-31

1. c 5. b 9. a 13. c 17. c
2. d 6. d 10. d 14. a 18. d
3. c 7. c 11. c 15. c 19. b
4. d 8. a 12. a 16. c 20. c

1. A firm with monopsony power hires fewer workers at lower wages than com-
petitive firms. Workers are more likely to join, and the union has more poten-
tial to increase wages without causing unemployment among its members. The
only way wages rise in competitive markets is if employment is reduced.
2. Yes, they and other intangibles, like investment in research and development,
patents, copyrights, and enhancing a brand name, should be treated as invest-
ments. The problem is that accounting for some of these investments can be dif-
ficult. How much of current advertising accounts for enhancing the brand, and
how much is to increase sales today? Other expenditures such as R&D and
tuition grants are easier to account for.
3. There are hung complementarities by everyone essentially working the same 5
days. You can count on people being available in your firm and in other firms as
well. At the other end, we want leisure time when our friends and family are off.
4. Four possibilities come to mind. First, fewer hours represent just a different
preference for leisure among German, French, and American workers, and a
willingness to give up some income for leisure. Second, both German and
French workers are highly productive at work, so most of what they need to do
is done in fewer hours. Third, highly progressive tax rates in both countries may
reduce work effort. Fourth, both countries are highly unionized, and fewer
work hours may simply be a result of that power.
5. Both the UAW and the domestic auto companies are in difficult positions. Aging
plants are not as productive as new plants run by Toyota, Honda, and others in
the United States. Because domestic firms are saddled with these high “legacy”
costs (generous retirement and health plans), newer companies have labor
costs less than half of that of General Motors. The UAW will have to be more
flexible and probably have to give back some benefits; cuts are inevitable. The
recent buyout helped, but the Job Bank provisions will probably not be in
future GM contracts. Requiring that workers be paid whether they worked or
not meant that GM had an incentive to keep producing even if demand declined,
pushing prices and profit margins downward. This was just the opposite of
what made good economic sense.
A- 32 Answers
6. The rise of global production powerhouses such as China, Japan, Korea, and
Indonesia have made it extremely difficult for unions to pressure firms to raise
wages. If too much pressure is brought to bear, the firm looks to outsource pro-
duction overseas. Further, competition from global firms has reduced former
oligopoly markets: Before, when increasing costs affected all firms, their costs
could be passed on to consumers without real alternatives; but now, highly
competitive markets have left firms from the old oligopolies at a disadvantage.
7. Productivity can be increased through investments in human capital, more flex-
ible work rules, improvements in technology, and increases in the amount of
capital employed with each worker. Unions can work with management to
implement all of these approaches.
8. Young people make up the bulk of college enrollment because their opportunity
costs are lower (they don’t command high wages), and once they graduate, they
can look forward to a long earning horizon. Middle-aged people have high
opportunity costs and a shorter future earning span. If interest rates rise dra-
matically, the costs of a college education go up if you must borrow, and the
higher future wages are discounted more heavily. Fewer people would attend
college (the rate of return has fallen), and those who do would be less likely to
be poor or need to borrow.
9. Yes it does. However, it also seems reasonable that a large part of a college edu-
cation represents a broadening of your mind, the acquisition of a set of analyt-
ical and communication skills, along with self-selection into an area where you
have an interest and show promise.
10. All things equal, if more people get college degrees, supply will eventually rise
and wages will not rise as fast, leading to a reduction in the rate of return to
your education.
11. While unions clearly have benefits, they also involve costs. First, there are dues
to pay. Second, higher wages mean fewer people are hired. Third, some people
have managerial responsibilities and are precluded from organizing a union or
are excluded from the bargaining unit. Fourth, many jobs don’t lend themselves
to union contract structure. These might include software engineering, sales,
and legal services.
12. Pilots are highly skilled, and the airlines spend huge sums on pilot training (and
retraining) and annual evaluations. Further, their salaries are a small part of the
overall costs of the airline, so high salaries have not been difficult to negotiate.
Flight attendants have less training, and there is a greater supply of people qual-
ified and willing to be attendants, making negotiations difficult for the flight
attendants unions.
13. Since part-time and contract employees work only temporarily for firms and
are geographically and industrially scattered, selecting the bargaining unit is
virtually impossible. The mix of skills and pay levels is so varied that even if all
businesses were willing to bargain, agreeing on a contract would be virtually
impossible.
14. When a higher-productivity individual is discriminated against because of race,
color, gender, age, religion, or disability, that individual loses, the employer
loses the added productivity, and consumers and society lose the added output.
When both labor and product markets are competitive, the firm that discrimi-
Answers A-33
nates and hires the lower-productivity individual will have higher costs as a
result, but competitors who do not discriminate will not. Discriminators will
earn lower profit than their competitors.
15. There is an inherent unfairness in different wages for the same job based on
race, gender, age, and the like. Plus, there is the relative importance of earning
a living versus going to the movies, and so on. Insurance is priced on an expe-
rience-based analysis and reflects different risks with different groups. Since
health insurance is important, our general policies on discrimination may not
be entirely consistent.

1. d 5. d 9. c 13. c 17. c
2. c 6. d 10. d 14. b 18. c
3. b 7. d 11. d 15. c 19. b
4. a 8. c 12. c 16. d 20. c

1. Yes, getting on board early allows companies to avoid lawsuits and punitive reg-
ulations later. The benefits are a better regulatory process faced by companies
and better public relations.
2. The naming of a new species by auction was recently done by the discoverers
of a new monkey in Bolivia. Bought by a Canadian online casino, we now have
the Golden Palace monkey. Many existing species have names based on
wealthy financiers of expeditions years ago. It might not seem right to change
a name at this point in time, but selling the right to name new species seems a
good idea. Of course, we could wind up with the American Airlines bear and the
Coca-Cola coyote.
3. It is a public good, neither rival nor exclusive. People buy these tags for the
same reason they support public radio and television. They support the cause
and also “feel good” about their purchase. Firms can use these tags as a show
of corporate support for green issues and get a head start on potential future
environmental regulations.
4. The answer depends on how concerned you are about the people who will live
80–100 years from now. The lower the discount rate, the more likely the project
would be financed today since harm way into the future would compute as a
higher value today, so reducing that harm today could stand up to higher cur-
rent costs. Using an 8% discount rate would mean the harm 100 years out would
have a small present value today.
A- 34 Answers
5. Public goods are nonrival in consumption (you and I can consume the same
good with no loss of satisfaction to each of us) and exhibit nonexcludability
(once the good is provided, no person can be kept from consuming it). Private
goods are both rival and exclusive (when I eat a candy bar, you can’t eat that
same bar).
6. This is a difficult set to put in order, given that many have a close mix of char-
acteristics. From roughly the most public in nature to the most private: the
Coast Guard, National Public Radio, summer spraying for mosquitoes, cable TV,
music downloaded from iTunes, a seat in a sports bar for Monday Night
Football, your economics class, a ski patrol at Aspen Mountain, an Oklahoma
toll road, a slice of pizza.
7. Working out an agreement was probably difficult for several reasons including
the emotional bubble surrounding smoking (my right to smoke vs. your right to
breathe clean air; and my house is my house, and I’ll do what I want). Since the
four-condo complex was old, the costs to prevent smoke penetration were
probably large. Either judgment would be efficient, but the distribution of ben-
efits and costs would differ. Now, the smoker will have to quit smoking or sell
out (presumably to nonsmokers, restricting the market somewhat). If the HOA
had lost, the other owners could have paid the smoker to quit, bought and
resold the property to nonsmokers, or rehabbed their condos enough to prevent
smoking odor from penetrating the walls.
8. Few people would be willing to restrict airline travel by increasing costs to dis-
courage its use by anyone but the wealthy. This could easily result in people
traveling by other forms of transportation that generate worse emissions. Note,
the general rule for greater pollution is when the marginal cost of getting rid of
it exceeds the marginal benefits. Airline pollution is a good case of where car-
bon trading will be used. Limit the pollution impact of air travel by requiring
carbon offsets equal to the impact of airline pollution at high altitudes.
9. Theoretically, internalizing externalities is the way to approach pollution con-
trol. It results in higher prices and reduced output and employment.
Implementing this concept is not easy in practice, and our huge environmental
protection bureaucracy is testimony to that fact. Globalization of production
makes it easier for companies to shop for environmentally favorable venues
when cleanup costs are significant.
10. Benefits such as a more informed electorate, the impact of reduced crime,
increases in taxes over the working lives of college graduates, and the impact
of higher productivity on economic growth.
11. Yes, climate change is a global phenomenon, and reductions in global warming
gases anywhere in the world are beneficial. Further, it pays to reduce those emis-
sions where the world gets the most “bang for the buck,” and methane is a partic-
ularly potent global warming gas, so eliminating much of it is an efficient
approach. Since the EU and other developing countries have spent more on envi-
ronmental controls than developing nations, reducing the pollution that aggra-
vates global climate change is cheaper (at the margin) in developing nations.
12. The Presidio in San Francisco is probably unique in that the value of the land
for development is so great that just a small part of the land can be leased to
generate enough revenue to run the park. In most other parks, such a plan
would not work given the remoteness of the parks.
Answers A-35
13. When resources are held in common—owned by everyone and not a single indi-
vidual (e.g., national parks, ocean fisheries, freeways, and African animals)—
they are typically overused. Regulation has been the traditional solution, but
recently, there have been some experiments with the idea of selling these
resources to private individuals to provide an incentive to protect and preserve
the resource.
14. Manufacturers could be required—or given tax incentives along with subsidies
to encourage recycling—to make as much of their packaging recyclable as pos-
sible. Add refundable deposits to a lot of products and packages, so they could
be redeemed for cash later (much like bottles today in some states). Another
approach would be to charge for each container of garbage picked up, but not
for recycled containers.
15. As very poor nations develop and incomes grow, the focus is on acquiring a
basic standard of living we take for granted. Acquiring more goods and services
ignores the environment since it can absorb considerable pollution at that
point, and achieving a minimum standard of living is more important. Once
economies reach a given level of consumption (per capita income), policy turns
to improving the quality of life (e.g., surroundings, environmental purity, and
improving health), and the community will not tolerate the same level of envi-
ronmental degradation it accepted when providing minimum levels of food and
shelter were the order of the day.

1. d 5. b 9. c 13. c 17. d
2. c 6. b 10. c 14. b 18. d
3. d 7. c 11. d 15. a 19. b
4. a 8. a 12. d 16. c 20. c
A- 36 Answers
100
80 Equal Distribution
Percentage of Income
60
A
40 B
20
0 20 40 60 80 100
Percentage of Families
1. a. See graph above.

b. Distribution A
c. Both of these are more equal than the distribution in the United States.
2. Yes. Over the life cycle of families, young people gain skills and see their
income rise, moving them out of the lower brackets into middle or upper quin-
tiles. Eventually earnings peak and families retire, and they may slip down a
quintile or two. All families have different life cycles, but the distribution over
time will be more equal than at a specific point in time.
3. The efficiency-equity tradeoff exists in this instance because you are taking
money from people who are working and earning to give to individuals who are
not. The efficiency issue is one of work effort on both ends. Taxing money from
those earning it reduces their incentive to work, while giving money to those
not working gives them an incentive not to work as well. The equity side is that
people not working or not earning enough money need that help to survive.
4. This question is designed to get you to think about the issue of setting poverty
thresholds. There is not a right or wrong answer; $20,000 a year is the equiva-
lent of a wage of $10 an hour for full-time workers. Frankly, this seems like con-
siderably small income to care for a family of four. But, keep in mind that any
number is essentially arbitrary.
5. Both of these impacts probably account for a significant portion of the growing
inequality of income in the U.S. The more than ten million unskilled illegal
immigrants reduce earnings in the lower quintiles, while the dual-earner house-
holds increase the earnings in the upper quintiles.
6. Family incomes differ because of inherited wealth, investment in human capi-
tal, physical and mental capabilities, discrimination, culture, attitudes, and
luck. The reasons are complex, and this is why public policy in this area is so
complex and clouded with emotion and politics.
Answers A-37
7. Probably. It may not be the absolute distribution that is important, but how it is
changing. A big change in the direction of inequality might be a reflection of a
growing problem, but clearly life cycle effects do reduce the importance of one-
period views of the income distribution.
8. The Lorenz curve is a graphical device to depict the income or wealth distribu-
tions plotting the cumulative sum of quintile shares of income or wealth on the
vertical axis and the cumulative sum of quintiles on the horizontal axis. The
Gini coefficient is the ratio of the area between the Lorenz curve and the equal
distribution line divided by the total area below the equal distribution line. Both
use the same data, but the Lorenz curve is graphical, whereas the Gini coeffi-
cient provides a specific number representing inequality.
9. With 10 million more high-income immigrants, the Gini coefficient would fall as
more of the population’s income would show up in the middle and higher
income groups. This would reduce the impact of the top group, making the dis-
tribution look more equal. Just the opposite would happen if more low-skilled,
low-income individuals enter the United States. They would exaggerate the
impact of upper-income groups and the Gini coefficient would rise.
10. At $12.50 an hour, a full-time minimum wage worker would earn $25,000 (40
hours ⫻ 50 weeks ⫽ 2,000 hours ⫻ $12.50 ⫽ $25,000). Thus a full-time worker
with a family would escape poverty. So far, so good. Unfortunately, many poor
people do not have sufficient skills to be hired at a wage rate of $12.50 an hour
with all the other costs of employment associated with hiring another worker
such as unemployment insurance, Social Security payments, and so on. And, for
various reasons, many people are unable to work, so poverty would persist.
Also, at $12.50 an hour, many minimum wage jobs would be eliminated.
11. Immediately the household income is split between two families, which may
take one middle-income family and create two lower-income families. Note also
that the poverty thresholds include some assumption of household efficiencies
since the thresholds grow slower as family size grows. Rising divorce rates
would undoubtedly change both the distribution of income and levels of
reported poverty.
12. With such a small fraction of personal income tax payments coming from the
bottom half of the income distribution, tax relief is an oxymoron. If the goal is
to help low-income working Americans, that help might be better addressed
with the earned income tax credit (EITC), whereby low-income families are
given a credit that adds to their tax refunds, even if they owe no taxes. This
credit, in effect, directly increases their income.
13. More of the poor today own their homes, own cars, have air conditioning,
watch cable or satellite TV, use cell phones, and have better health care.
Technology and Wal-Mart have increased the purchasing power of poor
incomes, and many new safety net programs have been introduced over this
half century.
14. Income inequality is due, for example, to differences in human capital, discrim-
ination, culture, attitudes about work and leisure, and the rise of two-earner
households. Income inequality is not inherently bad. Without different wage
rates (that lead to income inequality), incentives to excel would be harmed and
economic growth would slow.
A- 38 Answers
15. There seems always to be people who are in poverty for a short period (the
poor are not all the same people year after year) as they acquire the skills
needed to earn wages above poverty levels. This particularly applies to immi-
grants and young people. These life-cycle aspects make it more difficult to get
the poverty level below 10–15%. Lifestyle choices, disabilities, and discrimina-
tion are other reasons a certain level of poverty remains. Designing equitable
and efficient policies to reduce poverty below this apparent floor is difficult,
but clearly a worthwhile goal.

1. c 5. c 9. d 13. b 17. d
2. b 6. a 10. b 14. c 18. c
3. d 7. b 11. c 15. d 19. c
4. b 8. d 12. c 16. b 20. b

1. All spending in the economy necessarily equals payments to all of the factors of
production. A dollar spent adds up to a dollar in wages, interest, rents, or prof-
its.
2. Spending on the elderly today does little to improve the economy of the future.
Reduced investment today means lower GDP in the future because investment
in new capital, employee training, and research and development mean higher
output, higher salaries, and more new products and services in the future.
Further, sometime in the future, taxes must be raised to pay off the bonds or
continue paying interest.
3. The principal problem is estimating the value of these intangibles. How much is
an unlicensed patent worth? If something takes several years to develop, how
could we account for a project’s “value” before it is completed, not knowing if
it will be completed or if it will be accepted by the market? For many intangi-
bles, reasonable estimates could be made and included in GDP, making it a
more accurate statistic of our national output.
4. Taxes.
5. Norway, United States, China. (China is just now beginning to develop environ-
mental policies to deal with air pollution from burning coal and other problems
associated with its rapid growth and industrialization.)
6. Only getting GDP and related data quarterly makes policymaking more difficult.
We could conceivably be 6 months into a recession before policymakers are
sure of the data. Consequently, they must rely on other economic data to con-
Answers A-39
firm that the economy is turning down, and because of these information lags,
whatever action they take may be too late or too little, or actions are taken at
the same time the economy is turning in the other direction, causing policies to
heighten the business cycle.
7. The three major goals are full employment or low unemployment, robust eco-
nomic growth, and stable prices. In the last few years (2005–07), unemployment
has hovered around 5%, growth has been a solid 2.5% to 3.5% per year, and infla-
tion has been low; though recently inflation has shown signs of exceeding 3% a
year.
8. Business cycles are alternating increases and decreases in economic activity.
Business cycles include a peak at the top of the cycle, then a downturn (or
recession) as the economy cools off. Eventually the economy reaches the bot-
tom of the cycle or the trough followed by a recovery as business picks up and
the economy heads towards another peak. Business cycles are not dated by a
government agency, but by the National Bureau of Economic Research (NBER),
a nonprofit research organization founded in 1920.
9. A recession tends to be a relatively short downturn of modest severity. A
depression is longer and more severe. The old joke is this: A recession is when
your neighbor loses his job, and a depression is when you do.
10. The circular flow diagram shows how the product and factor markets interact
to produce goods and services and pay the factors of production. Ignoring some
of the statistical measurement difficulties, when goods or services are pro-
duced and sold, that spending must somehow be split among the factors of pro-
duction (and payments to): labor (wages), land (rents), capital (interest), and
entrepreneurial activity (profits).
11.
Year GDP C I G X–M C(%) I(%) G(%) X – M(%)

1965 719.1 443.8 118.2 151.5 5.6 61.72 16.44 21.07 0.78
1975 1638.3 1034.4 230.2 357.7 16 63.14 14.05 21.83 0.98
1985 4220.3 2720.3 736.2 879 –115.2 64.46 17.44 20.83 –2.73
1995 7397.7 4975.8 1144 1369.2 –91.4 67.26 15.46 18.51 –1.24
2005 12455.8 8742.4 2057.4 2372.8 –716.7 70.19 16.52 19.05 –5.75
a. Consumer spending (70.19 ⫼ 61.72 ⫽ 1.14).

b. Net exports, followed by investment.
c. Consumer spending went from 61.71 to 70.19.
12. GDP accounting adds up only the final value of goods and services to avoid
“double counting.” When the car is sold, the final price on the lot includes the
sum of the costs of the individual parts, and to count them again would be to
count them twice. For example, a $28,000 Toyota Prius has tires that Toyota
paid $120 for, plus other parts that add up to, say, $15,000. We would not want
to increase GDP by $43,120 ($28,000 ⫹ $15,000 ⫹ $120) when the car is sold,
that $15,120 in parts is already included in the $28,000 retail price.
A- 40 Answers
13. New residential construction is included in investment because of the long life
of housing; you don’t consume the entire housing services of a new house in the
year of purchase. Sales of existing houses are not included in GDP, because
GDP measures new production in that year.
14. The national income accounts take into account only market transactions and
ignore nonmarket and underground economy transactions. If you mow your
yard or clean your house, these activities, which improve your standard of liv-
ing, are ignored, but if you hire someone to do these activities, GDP rises as
they now pass through the market. All underground activities are also ignored.
Finally, some activities increase GDP, but do not improve our lives. Production
that pollutes increases GDP, but pollution costs are ignored.
15. GDP = C ⫹ I ⫹ G ⫹ (X – M) ⫽ (3,000 ⫹ 1,000 ⫹ 4,000) ⫹ 2,000 ⫹ 2,000
⫹ (1,200 – 1,800) ⫽ 12,000 – 600 ⫽ 11,400
NI ⫽ 7,000 ⫹ 900 ⫹ 150 ⫹ 1,200 ⫹ 550 ⫹ 800 ⫽ 10,600
NNP ⫽ 11,400 – 1,500 ⫽ 9,900

1. d 5. b 9. c 13. d 17. c
2. b 6. d 10. a 14. c 18. b
3. d 7. d 11. c 15. c 19. b
4. d 8. c 12. a 16. d 20. d

1. A favorable new report on job gains could bring discouraged workers or others
into the labor force. If the number of newcomers is greater than available jobs,
the unemployment rate would rise.
2. A falling unemployment rate could conceivably be due to a large number of dis-
couraged people dropping out of the labor force because they can’t find jobs, so
the number of people counted as unemployed declines, and so does the unem-
ployment rate.
3. More people in the population have entered the labor force and are employed.
To have increased employment by more than 40%, suffered early on a serious
recession (1981–82), and then suffer two mild recessions, only to see unemploy-
ment grow in absolute numbers by 5% suggests that this has been a period rep-
resenting a remarkably strong economy. No economy has a perfect record over
25-plus years, but the United States has had a record-breaking run over the last
three decades.
Answers A-41
4. By 154.9%. For our hypothetical example, adjusted for inflation, college gradu-
ates in 1980 were paid $1,542 a month ($1,200 ⫼ .778), and by January 2006,
they received $1,512 ($3,000 ⫼ 1.983).
5. If people are permitted to change jobs or be fired, frictional unemployment will
exist. It is the price of freedom in labor markets.
6. High rates of inflation caused by excessive government spending financed by
printing money reduces the value of existing monetary assets to near zero, gen-
erating abject poverty for many people. As hyperinflation continues, wages
must increase weekly, then daily, and workers must be paid daily so they can
spend before the value of their wages declines. All of this disrupts the normal
operating of an economy. People often revert to barter. Stopping hyperinflation
requires a new budget regime, new currency, and a strong commitment to
reduce the growth of the quantity of money in circulation.
7. Not in the labor force. You were not actively seeking work over the past 4
weeks.
8. The economy loses the output and income from those unemployed. Although
the unemployed lose income directly, we (the economy) lose jobs as well
because the unemployed would have spent most of their earnings, resulting in
greater employment and income. For those who want to work, not being able
to find a job is a serious psychological loss.
9. Teenagers and young people in general have not had enough time to acquire the
kinds of skills that are associated with lower unemployment rates (college edu-
cations, professional training, or trade skills beyond the apprenticeship period).
10. During a mild recession, the number of job losers would probably increase the
most, but when the recession is deep, the number of discouraged workers
would grow quite fast. In a boom, the number of job leavers would grow as peo-
ple change jobs with ease.
11. Frictional, structural, and cyclical. A job-matching employment service would
reduce search time for the frictionally unemployed. Extensive job training and
retraining programs would be most useful for structurally unemployed people.
Cyclical unemployment is minimized with good monetary and fiscal policies to
reduce the swings in the business cycle.
12. The four measures are the CPI, PCE, PPI, and the GDP deflator. The CPI
focuses on retail prices to consumers; the PCE targets consumer expenditures
in the GDP accounts, and it is a little broader measure of consumer inflation.
The PPI reflects prices received by domestic producers at the wholesale level.
The GDP deflator is the broadest measure of inflation; it includes all goods and
services covered by the national income and product accounts.
13. Adjusting 2004 median household income in real dollars, 44,389 ÷ 1.0837 =
$40,960.60. So, real median household income has grown slightly.
14. Workers lose temporarily (until adjustments are made over a longer time
period), because their wages have risen, but the goods and services they buy
have gone up in price. Creditors lose because inflation has reduced the value of
the payments they receive.
15. To be unemployed, you must not have a job, but must be available for work and
have been actively seeking work in the previous 4 weeks. The unemployment
A- 42 Answers
rate is the number of unemployed divided by the labor force (the sum of the
numbers employed and unemployed).
16.
Real GDP
GDP GDP Real GDP per Capita
(billions of Deflator (billions of Population (billions of
Year dollars) (2000 = 100) 2000 dollars) (millions) 2000 dollars)
1960 526.4 20.04 2,626.8 180.7 14,537
1970 1,038.5 27.53 3,772.3 205.1 18,393
1980 2,789.5 54.06 5,109.0 227.7 22,437
1990 5,803.1 81.61 7,110.8 250.1 28,432
2000 9,817.0 100.00 9,817.0 282.4 34,763
a.
(1) 9,817/526.4 ⫽ 18.65
(2) 100.00/20.04 ⫽ 4.99
(3) 9,817/2,626.8 ⫽5 3.74
(4) The general relationship among GDP, the price level, and real GDP is
GDP ⫽ real GDP ⫻ price level
So the changes in the three variables over 1960 to 2000 should be the same,
thus,
18.65 5 ⫽.99 3 ⫻.74
b. [(34,763 ⫺ 14,537)/14,537] ⫻ 100 ⫽ (20,226/14,537) ⫻ 100 ⫽ 139.1%. Yes,
people are 139% better off on average.
c. This is an average number for the economy and doesn’t reflect any changes
in the distribution of income and wealth. GDP per capita reflects output
and ignores the economy’s impact on the environment. These and other
issues were discussed in the previous chapter.

1. b 5. c 9. c 13. a 17. a
2. d 6. b 10. a 14. c 18. b
3. d 7. c 11. c 15. d 19. d
4. c 8. b 12. c 16. d 20. b
Answers A-43

1. Competition in product markets meant that worker’s wages were determined
by productivity. Competition in labor markets resulted in employment of all of
those willing to work at market determined wages. Say’s law meant that work-
ers spent their wages on products, so no surplus of output could result. If for
some reason people did save (Say’s law was not quite a law), competitive mar-
kets for capital and flexible interest rates would bring saving and investment
into equilibrium and keep the economy humming around full employment.
2. The magic of compound interest is most evident over long time periods. A
lower growth rate today would have little impact on our standard of living, but
that lower growth rate compounded over the next 50 years would mean a sig-
nificantly lower standard of living for your great grandchildren.
3. Not well. Many industries in the United States are not competitive in the classi-
cal sense. Unions and labor laws all reduce flexibility. This is one of the limita-
tions of the model. However, as your time horizon expands and all variables in
the economy can change, the classical model’s usefulness improves, especially
when you focus in on economic growth.
4. China’s per capita GDP in 50 years if it continues to enjoy real growth of 10%
annually will be $880,000 ($7,500 ⫻ 117.4), and the United States’ would be
$194,000 ($44,000 ⫻ 4.4). China would be a huge economy ($1,174 trillion) if it
can continue to grow at a 10% rate in the next 50 years. If the United States only
grows at 3%, it will only be $57.2 trillion. At a 5% grow rate, China would have
a GDP of $115 trillion, and its per capita GDP would be $86,300, half of the
United States if its growth rate was just 3%. Classical theory suggests that
growth comes from technology or innovation, increase in labor, or increase in
capital. To maintain a 10% real growth rate, China would need to grow all three
of these factors more than three times faster than the United States, and this
seems unlikely over a 50-year horizon.
5. Without the investments of past generations in infrastructure (roads, dams,
etc.), and investments in education and schools, for example, the U.S. economy
would be considerably smaller today and our standard of living would be lower.
6. Natural resources are helpful, but not necessary to have a vibrant and prosper-
ous economy. Japan, Hong Kong, and Singapore are clear examples of countries
without any significant resources that have high standards of living. These
countries do have large numbers of well educated productive people that have
contributed to growth.
7. Differential growth rates are the difference between abject poverty and pros-
perity. A country’s standard of living is based on past growth rates. Why one
country grows and another doesn’t—leaving its population living on less than 2
dollars a day—is clearly one of the most intriguing and important questions in
economics.
8. Economic freedoms include everything from encouraging private markets to
liberalized trade rules to free capital markets to protection of property rights. If
these kinds of freedoms are missing, many businesses will be local and small,
and the efficiencies of production and distribution are lost. Without economic
freedom, firms have little incentive or the ability to grow and invest.
A- 44 Answers
9. Foreign investment can help to jump-start an economy. Areas where the popu-
lation is poor can benefit from the jobs and income that foreign investment pro-
vides. As income grows, other firms develop to provide services and goods to
the employees of these foreign firms—now with higher incomes. But for many
countries, this is a balancing act to assure that foreign companies add to eco-
nomic growth and development without simply exploiting natural resources or
creating environmental problems. The goal is to see that these firms leave a per-
manent increase in economic growth and prosperity.
10. Saving can be encouraged by making more savings not subject to taxation. The
401(k) accounts used for private pensions in the United States are an example.
Focusing taxation more on consumption (sales taxes) rather than income will
encourage saving. Investment can be encouraged by tax policy as well. Using
investment tax credits that are an offset to tax liabilities reduces the cost of
investing, resulting in more. Also, investment by government in basic research
can often result in more research by private companies to turn these basic dis-
coveries into potential products. For example, the Human Genome Project
started by the U.S. government has led to significant research and development
by the drug industry into new treatments and drugs.
11. If population growth exceeds economic growth, per capita income will
decline—more people to spread the slower growing pie. Per capita income is a
reasonable measure to compare countries, but not perfect. Economic freedoms
also add to the quality of life, and governments provide different levels of serv-
ices (holding per capita income the same), and these add to standards of living.
Peter T. Bauer suggested that the birth of a cow adds to per capita GDP, but the
birth of a child subtracts from it; something here is not quite right.
12. As economies grow and per capita income rises, population growth rates typi-
cally fall, further adding to income, further slowing population growth. So this
may keep population from covering all of the earth. As economies grow and
prosper, the usage of resources becomes more efficient. Energy is an example
in which poor societies rely on wood, and as income grows, coal and oil take
over, and then power plants dispense power more efficiently as income grows
even further. Today, with higher energy prices, alternatives like solar and wind
may eventually provide considerable power. On the usage side, more energy-
efficient lightbulbs, for example, are making energy use more efficient.
Technology can reduce the quantity of natural resources needed for modern
products and reduce our overall usage.
13. Capital markets today are highly competitive and global; labor markets much
less so. If the labor market is not highly competitive, then some involuntary
unemployment will exist. Some people want jobs, but policies like minimum
wages, professional regulations, or union membership may prevent them from
working at the “prevailing” wage.
14. Investment in human capital such as education and improved health increase
the standard of living for individuals as they become more productive and earn
more throughout their working lives. For the economy as a whole there are pos-
itive spillovers from more productive workers. Also, higher levels of education
mean more workers are more able to use and create improving technologies.
15. When a country’s financial sector is subject to frequent crises or the currency is
subject to wide fluctuations in value, businesses and consumers find their nor-
Answers A-45
mal activities interrupted. This leads to economic uncertainty and reduces

investment in productive activities. Lower investment, and other poor eco-
nomic decisions because of financial uncertainties, reduce a country’s overall
growth rate.

1. d 5. d 9. c 13. d 17. b
2. c 6. c 10. b 14. d 18. d
3. d 7. b 11. c 15. a 19. c
4. b 8. d 12. d 16. c 20. d

1. Higher interest rates mean the cost of borrowing rises. Some consumers will
decide not to purchase items normally purchased on credit, so consumer
spending falls.
2. The APC is how much an individual consumes out of total income (C/Y),
whereas the MPC is the change in consumption associated with a change in
income (⌬C/⌬Y).
3. a. When Y ⫽ 2,300, APC ⫽ 1.035. When Y ⫽ 2,800, APS ⫽ 0.043.
b. MPC ⫽ 0.6; MPS ⫽ 0.4.
c. k ⫽ 1/(1 ⫺ MPC) ⫽ 1/MPS ⫽ 1/.4 5 2.5.
d. Y ⫽ 2,800.
e. See figure below.
S
e
120 I
Saving and Investment
a
0
24 25 26 27 28
Income (hundreds)
⫺80
4. The APC and the APS are the proportion of total income that is spent and saved.
We saw in problem 3 that at Y ⫽ 2,500, APC ⫽ 1, and APS ⫽ 0. But also in prob-
lem 3, MPC and MPS were always constant at MPC ⫽ 0.6 and MPS ⫽ 0.4. Note
A- 46 Answers
that the MPC and the MPS are equal to the change in consumption or saving
associated with a change in income and not necessarily equal to the proportion
spent or saved.
5. When the economy falls into a depression, consumption falls so significantly
that business can’t sell all it can produce and inventories grow more than
expected. With such excess capacity, few business are willing to invest in new
capacity to produce more that can’t be sold.
6. The multiplier is equal to 1/(1 ⫺ MPC) ⫽ 1/MPS. The multiplier exists because
an initial expenditure becomes someone’s income and a portion of this new
income is spent and some is saved. This new spending (MPC ⫻ new income)
now becomes someone else’s income to be spent, and so on.
7. When taxes are reduced by $100, this is essentially the same as income rising
by $100. Some of this increase in income is spent (consumed), and some is
saved. Thus, the initial impact of the tax reduction is muted by the portion that
is saved, reducing the ultimate impact on the economy.
8. a. With a multiplier of 4, MPC ⫽ .75, and MPS ⫽ .25.
b. The income gap is $1,000, so with a multiplier of 4, government spending
would have to rise by $250.
c. The balanced-budget multiplier is equal to 1, so government spending and
taxes would each have to rise by $1,000.
d. The multiplier is 4, so income rises by $400 to $3,400, and saving and invest-
ment will be equal to $500.
9. For example, an improvement in business expectations regarding the economy
and improvements in technology that stimulate innovations in new products.
10. Private investment typically leads to future increases in productive capacity
and often to increases in productivity. Both of these may improve our standards
of living in the future. Government spending on education, infrastructure, and
research and development has the capacity to do the same. But some govern-
ment spending is more like consumption and has little impact on the future. As
we will see in later chapters, if government spending is too high, it can “crowd
out” private investment, potentially reducing our rate of economic growth.
11. The MPC is 0.6 (300/500), the MPS is 0.4 (200/500), and the multiplier is 2.5
(1/0.4).
12. The multiplier is equal to 2.5 and income must grow by $1,000, so an aggregate
expenditure increase of $400 is required ($400 ⫻ 2.5 ⫽ $1,000). This is the
recessionary gap.
13. We learned in question 12 that an increase in aggregate spending of $400 was
needed to close the GDP gap of $1,000, since the multiplier is 2.5. Because only
0.6 (the MPC) of the tax reduction will be multiplied, we will need to reduce
taxes by more than $400. So the question boils down to what tax reduction
times 0.6 equals $400. The algebra is
400 ⫽ x(0.6)
400/0.6 ⫽ x
x ⫽ $667
So, a $667 tax reduction will close the GDP gap of $1,000.
Answers A-47
14. The GDP gap is $900 ($5,700 ⫺ $4,800). and with an MPC of 0.67. the multiplier
is 3 (1/(1 ⫺ .67) ⫽ 1/.33). So, the inflationary gap is the reduction in aggregate
expenditures needed to bring the economy down to $4,800 and is equal to $300
($900/3).
15. Unemployment during the Depression peaked at 25%, whereas today unemploy-
ment is around 5%. Today we have many programs that help poor and unem-
ployed people, such as welfare, unemployment compensation, and Medicaid;
these were virtually nonexistent in the 1930s. Thanks to Keynes, our under-
standing of macroeconomics is better today. Also, during the 1930s we did not
have a systematic process of data collection on the economy, so often policy-
makers made policy based on anecdotes.

1. d 5. a 9. b 13. d 17. b
2. c 6. d 10. d 14. c 18. c
3. b 7. c 11. d 15. d 19. d
4. c 8. d 12. b 16. c 20. d

1. Higher interest rates mean the cost of borrowing rises. Some consumers will
decide not to purchase items normally purchased on credit, so consumer
spending falls.
2. Since most of the benefits from IT are efficiency of production and distribution,
you should show a shifting of the AS curve to the right, resulting in a higher
equilibrium output at lower prices.
3. If aggregate demand declines, the price level falls (or inflation pressures are
reduced). If aggregate supply declines, the price level rises. Less inflation is bet-
ter than more.
4. When the economy is operating at full employment, an increase in AD just
translates into higher prices (inflation). Temporarily, the economy might
expand beyond full-employment output, but it quickly moves back along the
LRAS curve and back to full employment, but now the price level is even higher.
5. A leftward shift in the AS curve causes two problems for policymakers:
increased unemployment (lower output) and a higher price level (inflation). To
reduce unemployment by increasing AD will cause more inflation. To bring the
price level back to its original state would require AD to be reduced, increasing
unemployment even more.
A- 48 Answers
6. During a depression, the unemployment rate is high and the economy has sig-
nificant slack, so output can be increased with no effect on prices. In normal
short-run circumstances, employment is below full employment, and increasing
output may require overtime (hiring and training of people takes time and adds
to costs), so prices rise somewhat, resulting in a rise in the price level along
with rising output. But in the long run, the economy is at full employment, so
an increase in aggregate demand simply results in a rising price level.
7. a. The short-run equilibrium will be at point a where Q ⫽ $2,600.
b. Aggregate demand fell by 100, and the gap in GDP is 300, so the simple mul-
tiplier is equal to 3. Remember, when AD declines by x, and the economy
has a lot of slack, the change in equilibrium income, e ⫺ b, divided by the
change in aggregate demand is the multiplier.
8.
LRAS
AS1
AS0
Aggregate Price Level (P)
P2
P1 b
P0 e
AD1
AD0
0 Qf Q1
Aggregate Output (Q)
Initially, the economy will expand along the AS curve, AS0, and reach a tempo-
rary but short-lived equilibrium at point b, where output grows to Q1 and a new
price level of P1. At this point, labor and other input markets tighten, increasing
wages and costs. This causes the AS curve to shift to the left and continues until
the economy returns to full employment, but at a higher price level, P2.
9. Any factor that changes consumption, investment, government spending,
exports or imports will shift the aggregate demand curve. For example, a
change in personal taxes, wealth, or consumer confidence will change con-
sumption. Changes in interest rates or business forecasts for the economy will
change investment. Changes in income or exchange rates (the value of one cur-
rency for another) can change imports or exports. We will learn more about this
in later chapters. Unexpected events such as Hurricane Katrina or a war can
alter government spending.
10. Any change in the price of inputs will shift the aggregate supply curve. For
example, the recent worldwide increase of many commodity prices including
oil, copper, and aluminum eventually will reduce aggregate supply. A change in
productivity is another important factor that will shift the aggregate supply.
Changing tax rates, regulations, or business expectations about the economy
will also shift aggregate supply.
Answers A-49
11.
LRAS
150 AS

125 a
100 e
AD1
75
50
AD0
0 200 400 600 800 1,000

a. Q ⫽ 600, P ⫽ 100.
b. Q ⫽ 800, P ⫽ 125.
c. Long-run output will be at 600, and the new price will be between 125 and
150.
12. To solve demand-pull inflation, policymakers can just reduce aggregate demand
and the economy will return to full employment at the old price level. With cost-
push inflation, output falls and the price level and unemployment rise, so
increasing aggregate demand to bring the economy back to full employment
results in an even higher price level. Reducing aggregate demand makes the
recession worse.
13. Since consumer spending is roughly 70% of total spending, a small drop in con-
sumer spending results in a large change in equilibrium output and income.
Consumer confidence is one important factor driving consumer spending.
14. Japanese investment in the United States increased investment spending and
reduced imports of Japanese cars, increasing net exports. The rising value of
the yen made production in Japan relatively expensive; producing in the United
States made them more competitive. Yes, both situations represent firms seek-
ing production costs that keep them competitive.
15. It could affect aggregate supply on at least two possible levels. First, with all
workers covered, workers might become healthier and more productive,
increasing aggregate supply. Many companies today have “wellness” programs
that provide incentives (money and other rewards) to employees to eat right,
exercise, and generally take better care of their health. These programs reduce
sick days, health costs, and lead to more productive employees. Second, remov-
ing the responsibility of health care costs from private firms would reduce costs
to businesses and increase aggregate supply (this is the equivalent of lower
resource costs).
A- 50 Answers

1. c 5. d 9. c 13. d 17. b
2. b 6. c 10. d 14. b 18. a
3. d 7. c 11. d 15. c 19. d
4. d 8. a 12. c 16. d 20. c

1. An annually balanced budget would eliminate the automatic stabilization
aspect of the federal budget. When the economy enters a recession, the budget
normally moves toward a deficit as transfer payments increase and tax collec-
tions decline. With a balanced budget amendment, spending would have to be
cut back or taxes raised, causing the recession to be deeper. The benefit of such
an amendment is that the growth (or size) of the federal government would be
restricted.
2. Dunn has it right. When the economy enters a recession, surpluses will fall and
deficits will rise. Rising government spending and declining taxes (via auto-
matic stabilizers) will help to dampen a recession.
3. Mankiw and Weinzierl’s study is more consistent with point a. Tax rates are rel-
atively low, so the big economic growth impact is muted.
4. With half of the economy underground, legitimate firms must bear a bigger bur-
den of taxes. High tax rates keep small firms in the informal market from
becoming legal—the price is too high. High tax rates in this case are probably
keeping development low, and this explains Brazil’s high rate of poverty.
5. All government spending affects the economy. In contrast, some of the tax
cuts are saved, so only a part of the tax cut is spent, cutting its impact on the
economy.
6. Clearly, there are lags in implementing fiscal policy, but even if it comes a little
late, it is not entirely of no benefit. Without it, a recession could drag on for an
extended period, and losses could continue to pile up.
7. When a recession hits, these payments continue to be sent, cushioning con-
sumer spending. As part of the automatic stabilizers, and as the total number of
payments increase with the retirement of the baby boomers, variations in out-
put and employment may decline.
8. Increasing government purchases of goods and services is expansionary fiscal
policy. Buying goods from businesses increases aggregate demand, leading to
greater sales by firms, who will use these funds to purchase other goods, pay
factors, or invest in new production capacity. Combined with a multiplier
Answers A-51
effect, income and employment will expand. Raising taxes or reducing transfer
payments is contractionary since the government is reducing private income,
which will lead to reduced consumption.
9. Yes, it is a reasonable argument. Getting new government spending with a new
program on line is a time-consuming process. Further, reducing spending (or
eliminating programs) is often extremely difficult given the vested interests in
each government program. However, fiscal policy can be implemented much
faster for existing programs, and changes to income tax rates once they become
law are implemented quite quickly through withholding tables.
10. The mandatory part of the federal budget is approaching two thirds. As the
baby boom generation retires and goes on Social Security and Medicare, this
proportion will likely rise. However, even one third of the federal budget will
shortly approach $1 trillion, and this is still probably enough discretionary
spending to keep discretionary fiscal policy potent.
11. When the economy is booming and income is rising, people move into higher
brackets and the amount of taxes they pay rises faster than their income. This
process slows the growth of their disposable income, reducing their consump-
tion and acting as a brake to further economic growth. Just the opposite occurs
when the economy slides into a recession. Incomes fall, people move into lower
tax brackets, and their taxes fall faster than their income falls. This leaves them
with more disposable income. As a result, consumption falls less than income,
acting as a buffer against the recession.
12. Yes, it would reduce the robustness of the personal income tax as an automatic
stabilizer. Under a progressive tax system, a decline in income leads to a
greater-than-proportionate decline in tax liability, putting more income in the
hands of households. A flat tax is a proportionate tax, so the decline in tax pay-
ments and the increase in disposable income would be less. Taxes would still
be an automatic stabilizer, but their impact would be less.
13. When the economy is entering a recession, expansionary fiscal policy (increas-
ing government spending or transfer payments, or tax cuts) is called for. Cutting
taxes increases disposable income, leading to higher consumption and increas-
ing aggregate demand. The tax rebate checks to people were a one-shot injec-
tion of spending that may have helped cushion the impact of the recession,
since it turned out to be one of the mildest on record.
14. On the demand side, tax rate changes affect consumer income, which affects con-
sumer spending and, thus, aggregate demand. Tax rate changes also affect the
supply side by altering incentives of labor to work; higher tax rates discourage
work effort, while lower tax rates encourage work effort because take-home pay
is higher. Further, tax rates affect investment levels and the incentive to invest.
15. Keynesian analysis is primarily concerned with moving the economy out of a
depression. In dire times, business is so pessimistic that investments are put off
because excess capacity is abundant. In normal times, businesses are looking
to invest to expand capacity or upgrade (modernize) existing facilities in an
effort to increase productivity and reduce costs in the future. Often when gov-
ernments run deficits, it is for current consumption and not public investment.
By crowding out private investment, our economy is smaller in the future.
Today’s citizens are often consuming at a higher rate, pushing these costs to
future taxpayers.
A- 52 Answers

1. d 5. b 9. d 13. b 17. c
2. c 6. d 10. c 14. d 18. a
3. d 7. d 11. c 15. b 19. b
4. c 8. a 12. c 16. c 20. c

1. Money serves as a medium of exchange, a unit of account, and a store of value.
2. Barter requires a double coincidence of wants: You have to find someone who
produces what you want and wants what you have to trade. Barter networks
could exist, but the number of prices soon becomes unmanageable. Modern
economies are too complex with too many goods—barter would prevent the
attainment of a modern economy.
3. Money is less costly and easier to store than most of the goods we consume.
This is particularly true for digital money and credit cards.
4. Because required reserves make the banking system a “fractional reserve” system,
banks can lend only excess reserves (those in excess of required). When these
loans are deposited back into the banking system, they create further excess
reserves and loans, and so on. Theoretically banks can create up to 1 4 reserve
requirement (the money multiplier) of new money based on the initial deposit.
5. Checking accounts or demand deposits are liabilities to banks because deposi-
tors have loaned this money to the bank until they write checks and “demand”
this money be paid to someone else.
6. Banks hold excess reserves for several reasons, and this reduces the money
multiplier from its potential value. Some banks hold excess reserves to have
sufficient cash for ATMs and branches. When daily reserves are consistently
below those required, the bank must borrow from the Fed or the Federal Funds
Market, and this involves costs. Finally, bank regulators tend to look unfavor-
ably at banks that are always borrowing to shore up reserves, so this is some-
thing to avoid.
7. No. Reserves are required to prevent banks from becoming too extended finan-
cially and maintain that cushion to prevent the bank from not meeting its obli-
gations. More or less, the FDIC has provided sufficient security that runs on the
bank by depositors have been prevented.
8. M1 is essentially currency plus checkable deposits (demand deposits). M2 is a
broader definition that includes M1 plus other near monies such as saving
accounts and money market accounts.
Answers A-53
9. Remember that liquidity is determined by how quickly, easily, and reliably

assets can be converted into cash. The degree of liquidity of the last three items
on the list will depend on supply and demand, but real estate transactions
nearly always involve a lot of time and transactions costs (real estate agent
fees).
■ cash
■ checking account
■ savings account
■ 100 shares of Google
■ 1-caret diamond
■ Harley Davidson motorcycle
■ your old leather jacket
■ house (real estate)
10. Our money is fiat money—nothing but what it will buy is backing the currency.
We all have faith that the government will not debase the currency by printing
too much. Recall what the impact of hyperinflation is and how it devastates
existing financial assets.
11. Although Congress has supervisory authority over the Fed and consent over
appointments to the Board of Governors, the seven governors are appointed for
14 years with one term expiring every 2 years. This longevity of governors gives
the Federal Reserve its independence in policymaking, in much the same way
that tenure in universities fosters academic freedom. Most economists think
that Fed independence permits the Fed to set the tradeoffs among the three
goals of price stability, full employment, and robust economic growth. The
argument is that independence helps the Fed focus in a professional way on
keeping long-run inflation in check without the short-run distraction and polit-
ical pressure to expand the money supply to increase output and income
beyond what is prudent.
12. New York. The New York bank is the only bank to execute through open mar-
ket operations (buying and selling government bonds) the policy of the FOMC.
13. Open market operations are the most frequently used policy of the Fed, and
changing reserve requirements are the least. Reserve requirements are lumpy
changes that would have big effects. The Federal Reserve opts for more subtle
and precise changes: open market operations that can quickly adjust to chang-
ing conditions in a measured way.
14. Bonds have a fixed coupon rate of interest that results in a fixed dollar amount
paid out each year as an interest (coupon) payment. So, for example, a coupon
rate of 5% on a $1,000 par value bond would result in $50 paid to holders of the
bond each year. If market interest rates are 5%, then the market price of the
bond will be $1,000. But, if market interest rates should rise to 10%, the price of
the bond would fall to $500 because $50/$500 ⫽ 10%. Thus, as interest rates rise,
bond prices fall, and vice versa.
15. Inflation depreciates the currency’s value, and extreme inflation (hyperinfla-
tion) renders the currency worthless, creating a whole host of problems for
society including stifling growth and forcing people to turn to barter. By keep-
ing political pressure to continually expand the economy away from the
Federal Reserve, its decisions will reflect a more balanced approach to the
economy.
A- 54 Answers
16. a. The reserve requirement is equal to 35% ($700,000/$2,000,000).

b. The bank must keep 35% ($350,000) in reserves, so loans will rise by
$650,000.
c. Total deposits will equal $2,860,000, total loans will be $1,860,000, and total
reserves will equal $1,000,000.
d. The potential money multiplier is 1 ⫼ reserve requirement ⫽ 1/.35 ⫽ 2.86.

1. b 5. c 9. c 13. c 17. b
2. a 6. c 10. d 14. d 18. d
3. c 7. a 11. c 15. b 19. b
4. b 8. a 12. c 16. c 20. b

1. In the short run, monetary expansion can increase output, income, employ-
ment, and the price level and probably wealth as well. But over the long run,
increases in the money supply simply turn into higher prices, the conclusion of
monetarists and the classical school.
2. If energy prices double, then remain at the higher level, the price level will rise,
and output will fall in the short run. The inflation rate will bump up temporar-
ily, but then fall back to the level targeted by the Fed. The relative price of
energy has changed (one commodity), but unless the Fed accommodates the
energy price rise by expansionary monetary policy (increasing the supply of
money) to increase output, long-term inflation rates will not increase. Left
alone, the economy will adjust to higher energy prices without increasing the
long-term inflation rate.
3. Increasing the cost of borrowing (interest rates) will reduce investment and
consumer spending, reducing output and economic growth, thereby reducing
inflationary pressures.
4. Higher interest rates might affect the stock market for at least two reasons.
First, higher rates make bonds a more attractive investment. Second, high rates
mean the Fed is trying in some way to restrain the economy. This often means
slower growth and lower corporate profits.
5. Easy money policies (lower interest rates and a more rapid growth in the
money supply) ultimately lead to higher inflation rates in the long run. These
policies can also lead to excessive borrowing, insufficient saving, and unsus-
tainable asset prices (bubbles).
6. If the Fed were not independent, it would be subject to more political pressure.
Independence permits the Fed to focus on fighting inflation, along with appro-
Answers A-55
priate concerns about employment and output. Countries where the central
bank is not independent tend to have higher long-run inflation rates.
7. The equation of exchange helps explain the long-run relationship between the
money supply (M) and the price level (P). In the long run, velocity (V) is a func-
tion of institutions and technology, and the economy hovers around full
employment output (Q). As a result, V and Q are fixed, so changes in M lead
directly to changes in P.
8. The Fed either buys or sells government securities. When the government sells
securities, individual buyers or banks use checks or cash to buy those bonds.
As a result, the money supply immediately shrinks, as do bank reserves. This
leads to a further contraction in the money supply. To entice buyers to purchase
the bonds, the Fed may receive a lower price (the supply of bonds has now
increased), and these lower prices mean interest rates rise. The opposite is true
when the Fed buys bonds.
9. When interest rates are low, it can be difficult for the Fed to get any traction in
the economy by lowering rates further. Either a business investment is worth-
while, or it is not. By keeping rates low, the Fed kept the housing-construction
sector strong, and this investment somewhat offset the declines in investment
following the dot-com bust and the downturn in 2001. This was a tough choice
for the Fed; it seems to have worked, but may have resulted in the subprime
lending binge that led to a housing bubble that showed signs of collapsing in
2007.
10. One reason is that the opportunity cost of holding money is the interest rate;
when it falls, people are willing (and want to) hold higher money balances.
11. When the economy is considerably below full employment, increases in the
money supply will lead primarily to increases in output and income, with some
rise in the price level. But at full employment, increases in the money supply
lead primarily to increases in the price level.
12. The issue of transparency is difficult, controversial, and undergoing debate and
development. There is rarely complete agreement among policymakers, and
choices are made for a variety of reasons. When central bankers have an
explicit framework (inflation targeting), they can focus their analysis and pol-
icy statements around that target, making transparency easier.
13. The Federal Reserve’s response to demand shocks is effective because if, for
example, aggregate demand shifts to AD1, where the price level and output fall,
the Fed can use expansionary policy to return to the initial equilibrium point e.
The same is true if aggregate demand expands to AD2; contractionary policy
will bring the economy back to point e.
Supply shocks, on the other hand, pose a more difficult problem for the Fed.
If a negative supply shock hits the economy (energy prices jump), shifting the
aggregate supply curve to AS1, now the Fed faces a dilemma: Expansionary pol-
icy will bring the economy back to output Q0, but the price level will rise to P2
(point b). Using contractionary policy to return to the original price level will
make the recession worse as output declines to Q2 (point c).
A- 56 Answers
AS1
P2 b
a AS0

P1
c
P0 e AD2
AD0
AD1
Q2 Q1 Q0
14. Yes, it is very similar. The Fed makes policy based on where the economy is
today, and where they think it is going, but their policy changes take a long time
to have an impact. They differ in that Fed policymakers have a more complex
environment in which to make policy. Not only must the Fed worry about what
consumers and businesses in the United States will do, but they must also be
concerned with international impacts and changes as well.
15. Information and recognition lags. Supply shocks (oil price increases) may take
a while to work themselves through the economy. But, once they get a head of
steam, and more importantly, as consumers and businesses begin to build this
inflation into their expectations about the future, they can become a difficult
problem. Looking in the rearview mirror might be what the Fed would be doing
if it let inflation expectations into economy-wide decision making.

1. d 5. d 9. b 13. d 17. c
2. c 6. b 10. b 14. c 18. a
3. d 7. c 11. d 15. b 19. c
4. c 8. d 12. b 16. d 20. c
Answers A-57

1. Given that G ⫺ T ⫽ (S ⫺ I) ⫹ (M ⫺ X), for a given deficit or surplus and a given
level of investment and exports if S is larger, M will be smaller. So, net foreign
saving in United States will fall. The government can encourage saving and
matching a portion of savers funds—like 401(k) plans, or making a certain por-
tion of savings tax-free. Shifting from income taxes to consumption taxes
would encourage saving as well.
2. Since G ⫺ T ⫽ ⌬M ⫹ ⌬B ⫹ ⌬A, a deficit would only be inflationary to the
extent that it is financed by ⌬M. If the government (through the Fed) sells
bonds (⌬B) to the public, interest rates rise, thus dampening investment, out-
put, and inflationary pressures.
3. Marginal income tax rates approaching 70% were a disincentive for work and a
disincentive for a spouse to enter into the workforce as a second income
earner. Today, tax rates and high-income people are 35%, though most people
are way below that. The United States is probably on the left side of the Laffer
curve at this point. Some recent studies suggest that, even with added economic
growth, the government only recovers 10–20% of the tax revenue lost from low-
ering tax rates.
4. When the economy enters a recession, automatic stabilizers will reduce a sur-
plus. By reducing spending or increasing taxes, the impact of these automatic
stabilizers will be reduced, and quite probably, the recession will be worse.
Balancing the budget somewhat over the business cycle is preferred.
5. The surpluses generally require a booming economy in which tax revenues are
streaming in faster than politicians can spend them (rare), or a determined
effort by Congress to balance the budget. Congress finds it difficult to cut
spending (no one likes to preside over dismantling of a program), and con-
stituents always seem to have unmet needs.
6. One big benefit to business is that the government may be retiring (buying)
debt, so the government’s efforts to increase bond prices drives interest rates
down, making more investment prospects more attractive to business. Notice
that this is essentially the opposite of crowding out.
7. The inflationary impact of budget deficits is contingent on several factors,
including how the deficit is financed, how close the economy is to full employ-
ment, and the extent of the inflationary expectations in the economy. If the
deficit is monetized (⌬M ⬎ 0), the inflationary impact will be greater than if it
is financed by bonds. The closer the economy is to full employment, the more
likely price increases will result. And, as we will see in the next chapter, the
greater inflationary expectations are, the more likely inflation will result.
8. One thing that differentiates the government from private corporations is its
ability to print money (monetize the debt). Second, much (about half) is owed
internally, so these funds are just transfers among Americans. Corporations
would have trouble altering their existing contracts with pensioners (unless the
corporation is insolvent), but both Social Security and Medicare can be altered
by Congress. It probably would be a good idea to make such a calculation part
of the budget document each year—if only to remind us of the size and how it
is changing.
A- 58 Answers
9. In general, no. This is especially true when interest rates are low. However,
when interest rates climb, the real cost of paying added interest each year is
that it subtracts from money that could have been spent on other programs or
projects.
10. Probably not, for several reasons. First, open market operations are used as the
primary tool of the Federal Reserve; if all the debt were retired, this would com-
plicate its efforts. Second, many individuals, companies, and banks hold gov-
ernment securities because they are “risk-free.” This would make diversifying
their portfolios more difficult.
11. Ben Stein (and Standard & Poor’s) is referring to the fiscal imbalance caused by
the growing entitlement liabilities of Social Security, Medicare, and the pre-
scription drug program. Solving this problem will require increases in taxes,
cuts in the entitlements themselves, or cuts in other areas of the budget.
12. First, only half of the debt is held by the public. The other half is held by gov-
ernment agencies, so the left hand of the government owes the right hand
money with half of the total debt. Second, of the half held by the public, half of
that is held domestically, so the tax payments to pay the interest on the debt
goes to other Americans. Thus, roughly only one quarter of the debt is held by
foreigners, and that is a real claim on our resources, but that is a lot less than
what is implied by the gross public debt numbers. Third, if the economy is
growing faster than the debt is growing, then the debt as a percent of GDP is
declining. To the extent that GDP reflects the ability of the country to pay for
debt, our position is becoming better, even if the absolute size of the debt is
large.
13. The argument is that it’s mostly high-income (or wealthy) individuals who own
treasury bonds and they receive the interest, further skewing the income distri-
bution in favor of high-income people, adding to income inequality. In addition,
if the debt were less, more money currently paying interest on the debt could
be used to support low-income families, reducing income inequality.
14. Balancing the budget over the business cycle does seem like a reasonable
approach, since recoveries are typically longer than recessions. Two problems,
however, present themselves. First, when we are in recession, we don’t know
how long it will last, nor do we know how large a deficit is needed to help the
economy begin to recover. In addition, when in a recovery, the same is true, and
policymakers worry that the policies needed to run a surplus will bring a halt to
the recovery. Second, policymakers are politicians beset by special interest
groups that always see the need for new programs and fight reductions in
spending by the government. What programs are going to be cut?
15. Given that G ⫺ T ⫽ (S ⫺ I) ⫹ (M ⫺ X), if G ⫺ T went from a large positive to
zero and (S ⫺ I) did not change, then (M ⫺ X) would bear the brunt of the
entire adjustment and would have to become smaller by $300 to $400 billion. In
other words, because our imports are greater than our exports, imports would
have to fall or exports would have to rise, or a combination of both. Since some
of our imports are from Europe, it is likely that their exports to the United
States would fall, slowing the growth of their economies.
Answers A-59

1. b 5. b 9. d 13. a 17. c
2. d 6. d 10. c 14. d 18. d
3. b 7. d 11. c 15. d 19. d
4. d 8. d 12. b 16. d 20. d

1. Oil prices are rising, but the Fed does not have to push interest rates as severely
because inflationary expectations are considerably less. After the Fed’s per-
formance over the last three decades, people are confident that Fed policy will
be to keep inflation low over the long term.
2. When the economy has a lot of slack, say, when unemployment exceeds 6%, the
economy can expand with little pressure on prices. However, when the economy
approaches full employment (when unemployment gets below 4%), labor and
other markets tighten and any further expansion is met by rapidly rising prices.
3. Yes, the vertical long-run Phillips curve (LRPC) means that expanding aggre-
gate demand to move the economy to higher levels of employment when the
economy is at full employment will simply mean a higher level of inflation.
4. Expansionary monetary and fiscal policy designed to keep the economy below
the natural rate of unemployment leads to a higher rate of inflation (on the orig-
inal Phillips curve). This higher rate of inflation raises inflationary expecta-
tions, shifting the Phillips curve right and worsening the inflation-unemploy-
ment tradeoff. Now, to keep the economy below the natural rate requires more
expansionary policy, raising inflation even further. And thus the cycle repeats
itself.
5. Politicians, some policymakers, and some academics see unemployment as a
bigger problem than moderate inflation. For politicians, a low unemployment
rate makes reelection easier. Further, there are different views on how low
unemployment can be pushed before inflation becomes a problem.
6. No. Rational expectations imply that economic actors take into account all
available information and put that information into a reasonable economic
model. Economic actors are not always right, but there are no systematic biases
in their errors.
7. First, adjusting all factor payments would remove some of the pressure to keep
inflation low. Including product prices would be unworkable since many prod-
uct prices are actually falling even if inflation exists. Products with falling
demands and those with increasing supplies would not want prices raised since
inventories of these unsold items would just rise.
A- 60 Answers
8. Those who believe the world is best modeled with rational expectations see
policymaking as ineffective. If the economy consists of individuals and busi-
nesses that are governed by rational expectations, when policymakers decided
to implement some policy, people and business react in ways that are counter-
productive and render policy ineffective.
9. Under this assumption, anytime unemployment slipped below 7%, the U.S.
Federal Reserve and the Bank of Canada would tighten monetary policy.
Inflation would be very low (possibly even deflation), but most important, both
countries would be losing a lot of output and income as policymakers kept the
economy below full employment.
10. Inflationary expectations shift the Phillips curve rightward, worsening the
tradeoff between inflation and unemployment for policymakers. High inflation-
ary expectations make their job of reducing inflation harder. The speed at
which policymakers increase aggregate demand to return the economy to full
employment could affect inflationary expectations. For this reason, policymak-
ers typically try a slower growth path back to full unemployment to keep infla-
tionary expectations muted.
11. A steep slope would mean that small reductions in the unemployment rate lead
to large changes in inflation rates. The opposite is true for a shallow slope
curve. Thus, policymakers would prefer a shallow slope curve—low unemploy-
ment rates would be associated with lower inflation rates.
12. It would shift out and to the right. Now, higher unemployment rates are tem-
porarily associated with higher inflation rates. There would be no impact on the
long-run Phillips curve.
13. Both show equilibrium points for the economy at full employment over the long
run. The long-run aggregate supply curve shows long-run equilibrium rates for
the price level, while the long-run Phillips curve shows equilibrium rates of
inflation.
14. Probably. Today, even with energy prices rising, inflationary expectations are
low because individuals and businesses have confidence in the Fed’s commit-
ment to low inflation targets. This low level of inflationary expectations proba-
bly makes their job easier.
15. Probably. Estimates of the natural rate of unemployment in most European
countries exceed that of the United States. The difficulties associated with fir-
ing and laying off workers in Europe mean that employment costs are higher.
So firms are reluctant to hire new employees, unless demand is high and is pre-
dicted to remain high over the long term. Thus, reducing unemployment is
costly in terms of inflationary pressures.

1. c 5. d 9. b 13. c 17. c
2. d 6. d 10. a 14. a 18. d
3. c 7. b 11. c 15. d 19. b
4. d 8. c 12. d 16. c 20. d
Answers A-61

1. In general, the argument for trade liberalization is that both countries stand to
benefit or they would not voluntarily engage in trade. David Ricardo showed
how specialization in those areas where a country has a comparative advan-
tage, then trading meant gains for both countries. But as we have seen, there
are clearly winners and losers, and many groups on the losing end of trade
would probably not support further trade.
2. While not an industry with a huge economic impact, domestic film companies
have a cultural role to play. Many countries feel that foreign films will swamp the
existing industry and important art forms will be lost. Hollywood is their main
competitor. Guaranteeing local production companies that their films will be
shown exclusively half the time reduces the need (incentive) to be competitive.
3. A recognition of this problem of many people gaining at the expense of a few
workers prompted the federal government to provide trade assistance to those
industries harmed by trade agreements. For workers, this assistance involves
helping with retraining expenses.
4. Although the gains from trade are indeed large, we have very little information
on the distribution of the gains. Some would argue that the rich get the major-
ity of gains because there is little competition for their jobs, and they purchase
the bulk of high-priced imports. Others have different grievances with trade,
including environmental impacts and competition with low-paid foreign work-
ers for production jobs.
5. Although this is not the stated goal, it would be the impact if many foreign firms
or countries were required to meet our environmental and labor laws and wage
rates. Many countries are not at the stage of development where they can afford
to mimic U.S. infrastructure. Worker productivity in many countries is not high
enough to support high wages or the tax rates necessary for the level of govern-
ment services provided in the United States.
6. Yes to both. Outsourcing is leveraging the comparative advantage of other pro-
grammers. Open source programs (Linux and Open Office, for example) use the
comparative advantage of programmers around the world, controlled by a cen-
tral committee to ensure quality, but do not charge for the product itself.
7. The states of the United States generally have the same objectives and goals,
whereas countries often have very different cultures, goals, and objectives. This
is one of the difficulties the European Union is having in developing common
rules to, in effect, structure themselves in a similar way to the United States.
8. A country (or individual) has an absolute advantage when it can produce more
of a good or service than another. A comparative advantage exists when one
country’s opportunity cost to produce a good is lower than another country’s.
Michelle Wie would hire you to do laundry since your opportunity cost of doing
laundry is less than hers. In the 2 or 3 hours that it takes to do her laundry, she
could earn far more than what she would have to pay you.
9. Foreign auto firms built modern factories in the United States and avoided the
quota. Since foreign firms are building more cars in the United States in non-
union plants, it is difficult to see how UAW workers would gain. American con-
sumers would not gain from trade restrictions.
A- 62 Answers
10. It is very much like the gains from trade examples discussed in the chapter.
Developing nations send workers who produce output in developed countries,
and the developing world gets some income (remittances) in return. We benefit
and they benefit. Quite possibly the migrants to developed nations may reduce
wages for some jobs that domestic workers in these countries might do if the
pay was higher, so some domestic workers may suffer a loss as consumers reap
the benefits.
11. The U.S. government, California, and Australian (and other nations’) wine com-
panies would clearly benefit, and consumers of wine would lose.
12. a. India in tea, Italy in olives. India’s opportunity cost for 1 million tons of
olives is 15 million tons of tea. Italy’s opportunity cost for olives is 1.7 mil-
lion tons of tea for 1 million tons of olives. Italy’s opportunity cost for olives
is lower, so it will specialize in olive production.
b. See the table below. Yes, they both are better off, as shown in the last column.
Before After After

Country and Product Specialization Specialization Trade
Olives 6 million tons 12 million tons 6 million tons
Italy
Tea 10 million tons 0 30 million tons
Olives 4 million tons 0 6 million tons
India
Tea 30 million tons 60 million tons 30 million tons
13. a. At $10, unit total sales will be 16 million, with imports equal to the differ-
ence between 16 million total sales and domestic supply of 4 million units,
so imports will be 12 million and as a percent of U.S. sales are equal to
12/16 ⫽ 75%.
b. 4 million; at a price of $15 ($10 ⫹ $5 tariff), total sales are 12 million and
domestic supply is 8 million units.
c. Imports are 4 million times $5 a unit, so the total revenue from the tariff is
$20 million.
d. When the price was $10, domestic sales revenue was $10 ⫻ 4 million
units ⫽ $40 million. With the $5 tariff, sales revenue is $15 ⫻ 8 million
units ⫽ $120 million, so revenues have increased by $80 million. No wonder
domestic industries like tariffs on foreign products.
14. Trade barriers might save some jobs in specific industries, but as was the case
in the early 1930s, retaliatory trade restriction around the world led to a decline
of trade, output, income, and employment. Trade barriers lead to higher prod-
uct prices paid by all consumers for the benefit of jobs for a few.
15. Given that Brazil’s secret process is not cheap labor, domestic producers would
probably not get much of a hearing (they would be encouraged to develop their
own secret process). This is very much like the domestic auto industry going to
Washington for help in 2006 and being politely rebuffed. There really isn’t any
real difference; comparative advantage is comparative advantage.
Answers A-63

1. b 5. c 9. d 13. c 17. b
2. d 6. d 10. c 14. a 18. c
3. d 7. c 11. c 15. b 19. a
4. c 8. c 12. b 16. d 20. c

1. The balance of trade is the difference between exports and imports (X ⫺ M). As
noted in an earlier chapter, the U.S. budget deficit is contributing to the trade
deficit, and the trade deficit is affected by the low savings rate of U.S. con-
sumers. The demand in this country for imports exceeds world demand for our
exports.
2. In Table 1, remittances from foreigners working in the United States and send-
ing money home would be logged under the “Income Payments (outflow)” sub-
section “Net Transfers.”
3. The current account measures payments for exports and imports of goods and
services, incomes, and transfers of money in and out of the country. The capi-
tal account summarizes the flows of funds in and out of domestic and foreign
assets such as plant and equipment, ownership of companies, and so on.
4. Most current exchange rates are determined in foreign exchange markets by
the forces of supply and demand.
5. An appreciating euro means that the dollar buys fewer euros, and European
goods will now cost roughly 30% more in United States. Thus, fewer Mercedes-
Benz cars will be ordered, and imports of the vehicles will decline.
6. As wholesalers and other wine merchants need Australian dollars to purchase
wine, the demand for Australian dollars grows in the foreign exchange market,
causing the Australian dollar to appreciate. This is a dual-edged sword, how-
ever, as other Australian export products are now higher priced, making them
a little less competitive on world markets.
7. Relative to the euro, the dollar should become stronger as the exchange rate for
the euro drops. This would probably not affect the exchange rate between the
dollar and the yen or other non-European currencies.
8. Under a fixed exchange rate system, governments alter their macroeconomic
policies to maintain the exchange rate at a set level. Countries who adopt a flex-
ible exchange rate system let exchange rate markets adjust the exchange rate
to their macroeconomic policies.
A- 64 Answers
9. An increase in the money supply leads to lower interest rates and therefore a
capital outflow as investors seek higher returns elsewhere. This leads to a
weakening of the dollar, so imports fall while exports rise. Rising exports and
falling imports increase aggregate demand, improving income and output, and
making monetary policy a little stronger.
10. It takes 29.02 Mexican pesos to get a Bahrain dinar (2.6526 ⫼ .0914 ⫽ 29.02).
No, you could not afford the ferry trip because $20 U.S. is equal to $22.69
Canadian (20 ⫼ .8812 ⫽ 22.69). Yes, each Argentinean peso is worth 3.55
Mexican pesos, so 50 Argentinean pesos are equal to 177.95 Mexican pesos.
11. People holding large hordes of cash will be unable to redeem them for the new
notes. The poor will not be holding as much as the wealthy. The other group
harmed is black-market currency traders.
12. With a fixed exchange rate, countries begin to run out of gold to back the cur-
rency. The result is that to maintain a fixed exchange rate, they must contract
the money supply, forcing a recession on their countries.
13. Trade barriers and import taxes can play a role. The level of competition can
also be important. If a company has a monopoly in one country, and competi-
tion prevails in the other, relative prices will differ.
14. The nominal exchange rate is the price of one country’s currency for another.
The real exchange rate takes the price levels of both countries into account; it
is the nominal rate times the ratio of the price levels of the two countries. High
inflation in one country puts downward pressure on that country’s currency.
15. The dollar appreciates, so French wine will be cheaper as the dollar now buys
more euros. Yes, it would be a good time to go to Australia when the Australian
dollar is weak relative to the U.S. dollar. Exports in the United States will fall as
U.S. goods become more expensive on world markets.

1. c 5. c 9. b 13. b 17. d
2. d 6. b 10. c 14. b 18. d
3. b 7. a 11. a 15. c 19. d
4. a 8. d 12. a 16. c 20. d

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1. a. See graph above.

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Suggested Answers to Text Questions and Problems for Chapter 15

Year GDP C I G X–M C(%) I(%) G(%) X – M(%)

a. Consumer spending (70.19 ⫼ 61.72 ⫽ 1.14).

Answers to CourseTutor Homework Questions for Chapter 15

Suggested Answers to Text Questions and Problems for Chapter 16

Answers to CourseTutor Homework Questions for Chapter 16

Suggested Answers to Text Questions and Problems for Chapter 17

mal activities interrupted. This leads to economic uncertainty and reduces

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Suggested Answers to Text Questions and Problems for Chapter 18

Answers to CourseTutor Homework Questions for Chapter 18

Suggested Answers to Text Questions and Problems for Chapter 19

Aggregate Output (Q)

Aggregate Price Level (P)

0 200 400 600 800 1,000

Aggregate Output (Q)

Answers to CourseTutor Homework Questions for Chapter 19